Capital Structure


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Capital Structure

  1. 1.  Capital Structure  Meaning  Factors influencing capital structure  Optimal capital structure  Point of Indifference  Reasons for changes in capital structure  Leverages  Types of leverages  Definition “ Capital structure of a company refers to the composition of its capitalisation and it includes all long term capital sources i.e., loans, reserves, shares and bonds”. –Gerestenbeg “ the Capital structure of business can be measured by the ratio of various kinds of permanent loan and equity capital to total capital”. - Schwarty  Factors affecting capital structure  INTERNAL  Financial leverage  Risk  Growth and stability  Retaining control  Cost of capital  Cash flows  Flexibility  Purpose of finance  Asset structure  EXTERNAL  Size of the company  Nature of the industry  Investors  Cost of inflation  Legal requirements  Period of finance  Level of interest rate  Level of business activity  Availability of funds  Taxation policy  Level of stock prices  Conditions of the capital market  Optimal capital structure The OCM can be defined as “ that capital structure or combination of debt and equity that leads to the maximum value of the firm” OCM maximises the value of the company and hence the wealth of its owners and minimise the company’s cost of capital. the following consideration should be kept in mind while maximising the value of the firm in achieving the goal of the optimal capital structure: 1. If ROI > the fixed cost of funds, the company should prefer to raise the funds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS and MV of the firm.
  2. 2. 2. If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. 3. It should also avoid undue financial risk attached with the use of increased debt financing 4. The Capital structure should be flexible.  Point of indifference / Range of earnings The earnings per share, ‘equivalent point’ or ‘point of indifference’ refers to that EBIT, level at which EPS remains the same irrespective of Different alternatives of Debt-Equity mix. At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as the break-even level of EBIT for alternative financial plans Capital Gearing CG means the ratio between the various types of securities in the capital structure of the company. A company is said to e high-gear when it has proportionately higher/larger issue of Debt and PS for raising the LT resources. Whereas low-gear stands for a proportionately large issue of equity shares.  Leverage Leverage-an Increased means of accomplishing some purpose In financial management, it is the firms ability to use fixed cost assets or funds to increase the returns to its owners; Financial leverage- the use of long term fixed income bearing debt and preference share capital along with the equity share capital is called financial leverage or trading on equity A Firm is known to have a favourable leverage if its earnings are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an unfavourable leverage.  Impact of financial leverage When the d/f b/w the earnings from assets financed by fixed cost funds and cost of these funds are distributed to the equity stockholders, they will get additional earnings without increasing their own investment. Consequently, the EPS and the Rate of return on ESC will go up. On the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings from those assets then the EPS and return on equity capital will decrease.  Significance of financial leverage  Planning of capital structure  Profit planning Limitations of FL/ trading on equity  Double-edged weapon  Beneficial only to companies having stability in earnings  Increases risk and rate of interest  Restriction from financial instruments  Operating leverage Operating leverage results from the presence of fixed costs the help in magnifying net operating income fluctuations flowing from small variations in revenue. The changes in sales are related to changes in the revenue. The fixed costs do not change with the changes in sales, any increase in sales, FC remaining the same, will magnify operating revenue
  3. 3. OL shows the ability of a firm to use fixed operating cost to increase the effect of change in sales and the charges in fixed operating income.  Combined leverage  The OL affects the income which is the result of production. On the other hand, FL is the result of financial decisions. The CL focuses attention on the entire income of the concern  This leverage shows the relationship between a change in sales and the corresponding variation in taxable income. Working capital leverage This leverage measures the sensitivity of ROI of changes in the level of current assets.