Financial Management UNIT-2

Financial Management UNIT-2

Chapter-5 Capital structure

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Capital structure

Capital structure or capital framework of a company comprises of long term capital funds raised by it from different sources for the conduct of its business activities.
Various component of capital structure are raised from time to time to meet the demands and needs of a company which generally consist of :
  • Equity shares
  • Preference shares
  • Debt funds (bonds and debenture funds)
  • Borrowed or long term funds
  • Retained earnings
In simple words, capital structure is the composition of a firm's funds from different financing sources.

Capital framework may have a two fold impact on a company, which means the capital structure of a company affects the:
Cost of capital and
The valuation of a company

Optimal capital structure

Capital structure of a company may be considered as optimal or balanced one, if its financial plan has an appropriate debt equity mix which results in enhancing the company's value to the maximum level.

Maximization of the market value of a company's shares needs to be the objective of an optimal capital planning which is possible when each source of capital has the same marginal cost, the above concept is however, more theoretical in nature.

Optimal capital structure formed on the basis of preassumptions may go wrong as the capital markets are not perfect due to lack of information and exposure to risk.

But optimal capital structure should exhibit following essential characteristics in order to be termed as an optimal capital structure:

Profitability
Capital structure needs to conform with the objective of earning profit by minimizing the cost of capital and maximizing earnings per share.
Solvency
Capital structure of a company should be designed in such a way that it remains solvent.
Flexibility
Due to market forces, the management should be in a position to bring about various changes in the capital structure. Hence, it should be flexible.
Conservative
Capital structure of a company needs to be conservative as far as possible at the level of its debt components which simply means that the debt funds should be within the manageable limit of a company.
Control
Capital structure should be framed in such a way that there is the least chance of outsiders taking control over the company.
Simplicity
Simple components like equity or preference shares especially during the formative stage of a company should be given the utmost preference.
Liquidity
The liquidity position of a company is the determinant of its capability to meet the liability arising out of the debt capital. Hence, the capital structure of a company should always be in a manner that it can be liquidified at the time of need.

Components of capital structure

A) Owner's capital

1. Equity shares

These are the elementary source of raising funds.These are the most costly source of raising funds. Equity shareholders are the true owners of company and they have the highest level of business risk.
The balance of net profit after payments to all other claimants is distributed among equity shareholders.

2. Preference capital

Preference shareholders are given priority in dividend payout over ordinary shareholders.
Dividend should be paid at a fixed rate to preference shareholders.
Return of capital should be repaid at the time of winding up of the company to preference shareholders.

3. Retained earnings 

A part of net profit earned during the year is set aside for investment purposes and this is known as retained earning.
The company uses this earning for the growth and expansion of the business

B) Borrowed capital

1. Debentures 

When funds are raised through this mode, company enters into a contract with the subscribers of the ventures.
It had fixed interest rate of payment and it is the repable on a fixed maturity date.

2. Term loans

These are usually given by financial institutes.
The lenders are commercial banks and other financial institutions and they charge a fixed rate of interest for a period of 3 years or more.

Determinants of capital structure

1. Financial leverage or trading on equity

It can be defined as the optimal use of borrowed capital and owner's capital to increase the potential return on investment. 
Company with more debt than equity is considered to be highly leveraged.

2. Operating leverage 

It is the ratio of Company's fixed costs to variable costs. 
It is in the interest of the company to ensure that both the leverages are not at the high level at same time, either financial leverage should be lower than operating leverage or vice versa.

3. EBIT/EPS analysis 

Earning Before Interest & Tax  and Earning Per Share are two crucial indicators of Company's performance. A financial strategy with forecast of higher EPS is considered as the best.

4. Cost of capital

Overall cost of capital plays a vital role which revolves around the debt & equity ratio(DER).

5. Growth & stability of sales

Stable sales and increasing growth rate are the key performance indicators for having more borrowed fund as the company can pay off its liabilities through stablized sales.

6. Tax exposure of a company

Debt payment is tax deductible under Income Tax Act and hence, any company financing a project with higher debt fund can save lot of tax.

7. Flexibility

It is the outcome of a capital structure with low level of debt component 

8. Control

Excessive dependence on either "equity" or "debt" components may prove harmful to the company in long run.

9. Marketability 

10. Nature and size of industry

11. Industry standards 

12. Growth rate

13. Market conditions

14. Management style (Risk averse/conservative & aggressive)

15. Floatation cost(cost incurred while raising funds)

Importance of capital structure 

1. To reduce the overall risk of a company

Capital structure can act a risk management tool for a company if designed carefully and strategically.

2. To make adjustments according to businesse environment 

There is a need to have appropriate strategy for future capital mix to meet the future needs.

3. Idea generation for new source of fund.

NOTE:
Planning of capital structure involves four basic and most important analysis, viz,
EBIT/EPS Analysis
Cost of capital analysis
Cash flows analysis
Leverage analysis 

All three analysis have already been taught in other chapters so for now we will focus on the fourth analysis, viz,
●●●●●●●●●●●●●●●●●●●●●

Leverage Analysis 

Leverage refers to the use of fixed cost instruments to maximize the return potential for the shareholders.
In simple words, leverage can be defined as each and every variable  that has an impact on the returns available to the shareholders .

Types of leverage 

1. Financial leverage 

Also known as trading on equity. It is concerned with the financial structure of a firm.
It focuses on optimal use of financial resources in order to maximize the EBIT responding to higher EPS.

2. Operating leverage 

Operating leverage is related to the cost structure of a firm. It uses fixed costs incurred by a firm to maximize the returns. A cost is considered to be fixed when it remains the same even with the change in the output.

Formula for Operating leverage is:
And

3. Combined/Composite Leverage

Composite leverage is the amalgamation of operating leverage and financial everage.

Operating leverage determines the percentage change in operating profit in response to percentage change in sales. It defines the degree of operating risk. On the other hand, financial leverage is concerned with effect of percentage change in operating profit or EBIT on EPS. 

In this way, the leverage defines the degree of financial risk undertaken by the firm.

Composite leverage is used to describe the interrelationship between the sales revenue and taxable income. 



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