Download - Capital Structure Decisions-B.V.Raghunandan
Capital Structure Decisions- B.V.Raghunandan, SVS College, Bantwal-Karnataka-India
Meaning & Definition of Capital StructureCapital Structure is, ”the permanent financing of the firm represented by long-term debt, preferred stock and networth”
-Weston & Brigham
Planning the Capital Structure
Factors to be considered 1. Liquidity 2. Profitability 3. Ownership Control 4. Leverage 5. Nature of Industry 6. Funding Agencies’ Suggestions 7. Timing 8. Tax Planning 9. Growth Plans 10. Strategy
DebtAny source that gives the funding agency
the creditorship statusIn 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
In the vertical format, it is the II item (which again contains Secured Loans and Unsecured Loans) on the side of Sources of Funds
Features of DebtCompulsory Payment of Interest
Compulsory Repayment
Only Fixed Interest
No Annual Reports
No Voting Rights
Merits of DebtBenefit of LeverageCost of Raising
FundsTax AdvantageManagerial StabilityEasier SEBI NormsFlexible FeaturesStable Market for
Securities
Manageable Administrative Expenses
Flexible RepaymentEasier Regulatory
Compliance
Demerits of DebtCompulsory Payment of Interest
Solvency Affected
Compulsory Redemption
Charge on Assets
Credit Rate Shopping
Equity
Shareholders Fund or Ownership CapitalCompulsory Component of the Capital
StructureSum of Equity Share Capital, Preference
Share Capital and Reserves and SurplusPreference Shares are not a Popular
Instrument
Equity Shares
Common Stock/Ordinary SharesFull Fledged OwnershipTotal Entitlement to the AssetsRepayment After the Satisfaction of Every
Other ClaimPreemptive RightEntitlement for Dividend, Bonus Shares
and Other Such Rewards
Benefits of Equity SharesBasic for Capital
StructureBetter SolvencyGestation PeriodNo RedemptionNo Charge on
AssetsNo Shopping for
Credit Rating
Evaluation of Share Value
Better ImageCreation of ValuePublic Knowledge of
Financial Information
Demerits of Equity SharesTax ImplicationManagement ControlHigh Rates of
DividendLack of FlexibilityStringent SEBI
NormsHuge Issue
Expenses
High Volatility in the Stock Market
SpeculationComplex
Shareholder- Management Relation
Rigid Corporate Governance
Trading on Equity
Trading on Equity is, "the use of borrowed funds or preferred stock for financing”
-Guthmann & Dougal
Significance of Trading on Equity
A company having an ROI greater than the k can achieve a higher EPS for the equity shareholders
A company having a lower ROI than the k, will suffer financially because of inability to meet the fixed interest commitment
Preparation of Statement of Income
Leverages: Operating Leverage, Financial Leverage and Combined Leverage
Degree of LeveragesSignificance of Each Leverage: -Sales-EBIT-EPS Relation -Measurement of Risk Levels -Behaviour of Costs
Proforma of a Statement of Income
Particulars Amount Rs.
Sales ---------
(-) Variable Cost ----------
Contribution -----------
(-) Fixed Cost ------------
Operating Profit/EBIT ------------
(-) Interest ------------
Earning Before Tax (EBT) -----------
(-) Tax -----------
Earning After Tax (EAT) ------------
(-) Preference Dividend ------------
Surplus Profit -------------
Computation of Earning per Share
aresofEquityShNo
ofitSurplusEPS
.
Pr
Problem No.1Show the EBIT for the following set of
data: P=Rs.10, Q= 20,000 V= Rs.6 F=50,000
(July,2006)Solution:EBIT=S-V-F = (20,000x10)-(20,000x6) –
- 50,000 = Rs.30,000
Leverages
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)
Trading on Equity is the cause and Leverage is the effect
Three Types of Leverages: Operating Leverage, Financial Leverage and Combined Leverage
Operating Leverage
It is a benefit derived by the presence of fixed cost in the cost of manufacturing
It helps in determining the magnifying impact of a certain percentage of increase in sales on the EBIT
An operating leverage of 2 indicates that a 10% increase in sales will result in 2x10%,i.e 20% increase in the EBIT
Financial Leverage
It is the benefit derived due to fixed interest or fixed dividend securities in the capital structure of the company
It is measure that helps us in determining the magnified impact of a certain percentage of increase in the EBIT on the EPS
A Financial Leverage of 3 indicates that a 10% increase in the EBIT results in a 30% increase in the EPS
Combined/Total LeverageIt is the total benefit derived from
operation and financing due to fixed costs and fixed dividend or fixed interest
It measures the magnifying impact of a certain percentage of increase in sales on the EPS
A combined leverage of 5 indicates that for every 10% increase in sales, there will be a 50% (5x10%) increase in EPS
Determination of Operating Leverage (OL)
EBIT
onContributiOL
Determination of Financial Leverage (FL)
EBT
EBITFL
Determination of Combined Leverage
EBT
onContributiCL
Problems
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
The sales of a company amounted to Rs. 60,000 and the variable cost was
30%. of sales. Fixed cost was Rs. 32,000. Compute the operating leverage
Problems------2
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
A firm has an operating leverage at 2.5. If the sale increases by 10%, Calculate the percentage of increase in EBIT (Operating Profit).
Problems-------3
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?
Problems----------4
Calculate operating leverage, financial leverage and composite leverage from thr following data
Sales(1,00,000 units)- Rs.2,00,000 Variable Cost/unit - Rs.0.70 Fixed Cost - Rs.65,000 Interest Charges - Rs.15,000 (July, 2006)
Problems------------5Calculate DOL, DFL,DCL for the three firms
from the data given below and interpret the results
P Q ROutput(units) 3 lakh 75,000 5 lakhFixed Cost(Rs)3.5lakh 7lakh 75,000VC/Unit (Rs) 1.00 7.50 0.10Interest (Rs)25,000 40,000 -Price/Unit (Rs) 3.00 25.00 0.50 (June,2005)
Dividend Policies
Involves distribution of Cash Dividend and declaration of Bonus shares
Cash Dividend distributed decides the image of the corporate in the market
May decide the market priceAlso has an impact on the valuation of
sharesAlso decides the profit retained in the firm
Factors Affecting the Dividend PolicyCorporate PolicyStable earningsLiquidity of the
CorporatePast dividend RatesPresent ProjectsMarket ExpectationTaxationLegal restrictionBonus Needs
Investment Opportunities
Restrictions of FIsNature of BusinessCost of CapitalPhase of Trade
CycleAcc.ReservesGrowth Needs
Types of Dividend Policies
Stable Dividend Policy
Stable Dividend Pay-Out Policy
Stable Dividend Policy
The percentage of Dividend is kept stableThe increase in percentage is only
moderate over a long period of timeStable Image for the CorporateStability in the market priceEasy management of liquidityHelps in Building up the ReservesEasy maintenance of the Rate over a long
period
Stable Dividend Pay-Out PolicyA certain percentage of the surplus profit is
distributed year after yearHigher surplus results in a higher
percentageShareholders enjoy during periods of growth
and prosperity and suffer during recessionFluctuating market PriceLeading to Speculation in the trading in the
shares
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