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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