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Capital Structure Decisions-B.V.Raghunandan


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Deals with debt funds, equity funds and their mixture

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Capital Structure Decisions-B.V.Raghunandan

  1. 1. Capital Structure Decisions-B.V.Raghunandan, SVS College, Bantwal-Karnataka-India<br />
  2. 2. Meaning & Definition of Capital Structure<br />Capital Structure is, ”the permanent financing of the firm represented by long-term debt, preferred stock and networth”<br /> -Weston & Brigham <br />
  3. 3. Planning the Capital Structure<br />Factors to be considered<br /> 1. Liquidity<br /> 2. Profitability<br /> 3. Ownership Control<br /> 4. Leverage<br /> 5. Nature of Industry<br /> 6. Funding Agencies’ Suggestions<br /> 7. Timing<br /> 8. Tax Planning<br /> 9. Growth Plans<br /> 10. Strategy <br />
  4. 4. Debt<br />Any source that gives the funding agency the creditorship status<br />In the horizontal form of Corporate Balance Sheet, it is the sum of III and IV items(Secured Loans and Unsecured Loans) on the Liabilities side of the Balance Sheet<br />In the vertical format, it is the II item (which again contains Secured Loans and Unsecured Loans) on the side of Sources of Funds<br />
  5. 5. Features of Debt<br />Compulsory Payment of Interest<br />Compulsory Repayment<br />Only Fixed Interest<br />No Annual Reports<br />No Voting Rights<br />
  6. 6. Merits of Debt<br />Benefit of Leverage<br />Cost of Raising Funds<br />Tax Advantage<br />Managerial Stability<br />Easier SEBI Norms<br />Flexible Features<br />Stable Market for Securities<br />Manageable Administrative Expenses<br />Flexible Repayment<br />Easier Regulatory Compliance<br />
  7. 7. Demerits of Debt<br />Compulsory Payment of Interest<br />Solvency Affected<br />Compulsory Redemption<br />Charge on Assets<br />Credit Rate Shopping<br />
  8. 8. Equity <br />Shareholders Fund or Ownership Capital<br />Compulsory Component of the Capital Structure<br />Sum of Equity Share Capital, Preference Share Capital and Reserves and Surplus<br />Preference Shares are not a Popular Instrument<br />
  9. 9. Equity Shares<br />Common Stock/Ordinary Shares<br />Full Fledged Ownership<br />Total Entitlement to the Assets<br />Repayment After the Satisfaction of Every Other Claim<br />Preemptive Right<br />Entitlement for Dividend, Bonus Shares and Other Such Rewards<br />
  10. 10. Benefits of Equity Shares<br />Basic for Capital Structure<br />Better Solvency<br />Gestation Period<br />No Redemption<br />No Charge on Assets<br />No Shopping for Credit Rating<br />Evaluation of Share Value<br />Better Image<br />Creation of Value<br />Public Knowledge of Financial Information<br />
  11. 11. Demerits of Equity Shares<br />Tax Implication<br />Management Control<br />High Rates of Dividend<br />Lack of Flexibility<br />Stringent SEBI Norms<br />Huge Issue Expenses<br />High Volatility in the Stock Market<br />Speculation<br />Complex Shareholder- Management Relation<br />Rigid Corporate Governance<br />
  12. 12. Trading on Equity<br />Trading on Equity is, "the use of borrowed funds or preferred stock for financing”<br /> -Guthmann & Dougal<br />
  13. 13. Significance of Trading on Equity<br />A company having an ROI greater than the k can achieve a higher EPS for the equity shareholders<br />A company having a lower ROI than the k, will suffer financially because of inability to meet the fixed interest commitment<br />
  14. 14. Preparation of Statement of Income<br />Leverages: Operating Leverage, Financial Leverage and Combined Leverage<br />Degree of Leverages<br />Significance of Each Leverage: <br /> -Sales-EBIT-EPS Relation<br /> -Measurement of Risk Levels<br /> -Behaviour of Costs<br />
  15. 15. Proforma of a Statement of Income<br />
  16. 16. Computation of Earning per Share<br />
  17. 17. Problem No.1<br />Show the EBIT for the following set of data:<br /> P=Rs.10, Q= 20,000 V= Rs.6 F=50,000<br /> (July,2006)<br />Solution:<br />EBIT=S-V-F = (20,000x10)-(20,000x6) – <br /> - 50,000 <br /> = Rs.30,000 <br />
  18. 18. Leverages<br />Leverage is the benefit that accrues to the equity shareholders due to debt (carrying fixed rate of interest) or preference shares (carrying fixed rate of dividend)<br />Trading on Equity is the cause and Leverage is the effect<br />Three Types of Leverages: Operating Leverage, Financial Leverage and Combined Leverage<br />
  19. 19. Operating Leverage<br />It is a benefit derived by the presence of fixed cost in the cost of manufacturing<br />It helps in determining the magnifying impact of a certain percentage of increase in sales on the EBIT<br />An operating leverage of 2 indicates that a 10% increase in sales will result in 2x10%,i.e 20% increase in the EBIT <br />
  20. 20. Financial Leverage<br />It is the benefit derived due to fixed interest or fixed dividend securities in the capital structure of the company<br />It is measure that helps us in determining the magnified impact of a certain percentage of increase in the EBIT on the EPS<br />A Financial Leverage of 3 indicates that a 10% increase in the EBIT results in a 30% increase in the EPS <br />
  21. 21. Combined/Total Leverage<br />It is the total benefit derived from operation and financing due to fixed costs and fixed dividend or fixed interest<br />It measures the magnifying impact of a certain percentage of increase in sales on the EPS<br />A combined leverage of 5 indicates that for every 10% increase in sales, there will be a 50% (5x10%) increase in EPS <br />
  22. 22. Determination of Operating Leverage (OL)<br />
  23. 23. Determination of Financial Leverage (FL)<br />
  24. 24. Determination of Combined Leverage<br />
  25. 25. Problems<br />A company sells 40,000 units at Rs. 50 per unit. Variables cost is Rs. 40 per unit, and the fixed cost is 2,00,000. Compute the operating leverage<br />The sales of a company amounted to <br /> Rs. 60,000 and the variable cost was 30%. of sales. Fixed cost was Rs. 32,000. Compute the operating leverage<br />
  26. 26. Problems------2<br />The EBIT of a firm was Rs. 75,000 and the interest burden was Rs. 50,000. Applicable tax rate was 40%. Compute the Financial Leverage<br />A firm has an operating leverage at 2.5. If the sale increases by 10%, Calculate the percentage of increase in EBIT (Operating Profit).<br />
  27. 27. Problems-------3<br />If the Operating Leverage is 3 and financial leverage is 2, what is the combined leverage? If the sales increase by 35%, what will be the percentage of increase in the EPS?<br />
  28. 28. Problems----------4<br />Calculate operating leverage, financial leverage and composite leverage from thr following data <br /> Sales(1,00,000 units)- Rs.2,00,000<br /> Variable Cost/unit - Rs.0.70<br /> Fixed Cost - Rs.65,000<br /> Interest Charges - Rs.15,000<br /> (July, 2006)<br />
  29. 29. Problems------------5<br />Calculate DOL, DFL,DCL for the three firms from the data given below and interpret the results<br /> P Q R<br />Output(units) 3 lakh 75,000 5 lakh<br />Fixed Cost(Rs)3.5lakh 7lakh 75,000<br />VC/Unit (Rs) 1.00 7.50 0.10<br />Interest (Rs)25,000 40,000 -<br />Price/Unit (Rs) 3.00 25.00 0.50<br /> (June,2005)<br />
  30. 30. Dividend Policies<br />Involves distribution of Cash Dividend and declaration of Bonus shares<br />Cash Dividend distributed decides the image of the corporate in the market<br />May decide the market price<br />Also has an impact on the valuation of shares<br />Also decides the profit retained in the firm<br />
  31. 31. Factors Affecting the Dividend Policy<br />Corporate Policy<br />Stable earnings<br />Liquidity of the Corporate<br />Past dividend Rates<br />Present Projects<br />Market Expectation<br />Taxation<br />Legal restriction<br />Bonus Needs<br />Investment Opportunities<br />Restrictions of FIs<br />Nature of Business<br />Cost of Capital<br />Phase of Trade Cycle<br />Acc.Reserves<br />Growth Needs<br />
  32. 32. Types of Dividend Policies<br />Stable Dividend Policy<br />Stable Dividend Pay-Out Policy<br />
  33. 33. Stable Dividend Policy<br />The percentage of Dividend is kept stable<br />The increase in percentage is only moderate over a long period of time<br />Stable Image for the Corporate<br />Stability in the market price<br />Easy management of liquidity<br />Helps in Building up the Reserves<br />Easy maintenance of the Rate over a long period <br />
  34. 34. Stable Dividend Pay-Out Policy<br />A certain percentage of the surplus profit is distributed year after year<br />Higher surplus results in a higher percentage<br />Shareholders enjoy during periods of growth and prosperity and suffer during recession<br />Fluctuating market Price<br />Leading to Speculation in the trading in the shares<br />
  35. 35. THANK YOU<br />