2. Capital Structure
The capital structure is how a firm finances its overall
operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes
payable, while equity is classified as common stock, preferred
stock or retained earnings.
Short-term debt such as working capital requirements is also
considered to be part of the capital structure.
3. Capital structure planning
Capital structure planning is very important to survive
the business in long run.
After simple watching the balance sheet of company, you see
two sides of balance sheet. One side is liability side and other side
is asset side.
Liability side is the mixture of finance of company and it has been
used or will be used for development of company. Liability side of
balance sheet is made under perfect capital structure planning
4. Capital structure planning makes strong balance sheet.
The right capital structure planning also increases the power of
company to face the losses and changes in financial markets.
5. Optimal capital structure is a mix of debt and equity that seeks to
lower the cost of capital and maximize the value of the firm.
To calculate the optimal capital structure of a firm, analysts
calculate the weighted average cost of capital (WACC) to determine
the level of risk.
Optimal Capital Structure
6. Leverage
Leverage refers to the employment of assets or sources of fund
bearing fixed payment to magnify EBIT or EPS respectively.
So it may be associated with investment activities or financing
activities.
8. Operating Leverage
Operating leverage is concerned with the investment activities
of the firm. It relates to the incurrence of fixed operating costs
in the firm’s income stream.
The operating cost of a firm is classified into three types:
Fixed cost
Variable cost
Semi-variable or semi-fixed cost
9. Fixed cost is a contractual cost and is a function of time. So it
does not change with the change in sales.
Variable costs vary directly with the sales revenue.
If no sales are made variable costs will be nil.
Semi-variable or semi-fixed costs vary partly with sales and
remain partly fixed.
Operating Leverage = % change in EBIT / % change in Sale
10. Financial leverage
Financial leverage is known as trading on equity .
If any company's finance manager knows that company's return
on investment is more than interest on loan,
At this time , if company needs more money , then finance
manager gets its loan and bought the asset from same loan.
So, any technique in which any asset is purchased with loan and
trying to increase EPS , then this is called financial leverage .
11. Financial leverage = % change in Earning per share / %
change in earning before interest and tax
12. Combined leverage
It is the product of operating leverage and financial leverage.
Combined leverage = Operating leverage X financial leverage
= % change in EBIT / % change in sale X % change in EPS / %
change in EBIT
13. Cost Of Capital
The cost of a firm is the minimum rate of return expected by its
investors . It is the weighted average cost of various sources of
finance used by firm.
“ A cost off rate for the allocation of capital to investment of
projects. It is the rate of return on a project that will leave unchanged
the market price of the stock”.
14. Components of Cost of Capital
A firms cost of capital include 3 components:
1- Return at zero risk level:- It relates to the expected rate of return
when a project involves no financial risk.
2- Business risk premium:- Generally business risk premium is
determined by the capital budgeting decisions for investment
proposals. If the firm selects a project which has more than the
normal risk, the suppliers of the funds for the project will naturally
expect a higher rate of return than the normal rate . Thus the cost of
capital increases.
3- Financial risk premium:- Financial risk relates to the pattern of
capital structure of the firm. A firm which has higher debt content in
its capital structure should have more risk than a firm which has
comparatively low debt content.
15. The above 3 components of cost of capital may be written in the form
of the following equation.
K= r0+b+f
Where,
K= Cost of Capital
r0= return at 0 risk level
b= business risk premium
f= financial risk premium
16. Classification of cost of
capital
There are four types of cost of capital such as;
1- Historical cost and future cost
2- Specific cost and composite cost
3- Average cost and Marginal cost
4- Explicit cost and implicit cost
17. Significance of the cost of
capital
As an acceptance criterion in capital budgeting the acceptance or
rejection of the project is decided by taking into consideration the
cost of capital.
As a determinant of capital mix in capital structure decision –the
objective of maximising the value of the firm and minimizing the
cost of capital results in optimal capital structure.
As a basis for evaluating the financial performance- the
profitability is compared to projected overall cost of capital and
the actual cost of capital of funds raised to finance the project.
As a basis for taking other financial decisions – Like dividend
policy , capitalisation of profits ,making the right issue , working
capital.
