Deals with debt funds, equity funds and their mixture

1. Capital Structure Decisions-B.V.Raghunandan, SVS College, Bantwal-Karnataka-India

2. Meaning & Definition of Capital Structure Capital Structure is, ”the permanent financing of the firm represented by long-term debt, preferred stock and networth” -Weston & Brigham

3. 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

4. Debt Any source that gives the funding agency the creditorship status In 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

5. Features of Debt Compulsory Payment of Interest Compulsory Repayment Only Fixed Interest No Annual Reports No Voting Rights

6. Merits of Debt Benefit of Leverage Cost of Raising Funds Tax Advantage Managerial Stability Easier SEBI Norms Flexible Features Stable Market for Securities Manageable Administrative Expenses Flexible Repayment Easier Regulatory Compliance

7. Demerits of Debt Compulsory Payment of Interest Solvency Affected Compulsory Redemption Charge on Assets Credit Rate Shopping

8. Equity Shareholders Fund or Ownership Capital Compulsory Component of the Capital Structure Sum of Equity Share Capital, Preference Share Capital and Reserves and Surplus Preference Shares are not a Popular Instrument

9. Equity Shares Common Stock/Ordinary Shares Full Fledged Ownership Total Entitlement to the Assets Repayment After the Satisfaction of Every Other Claim Preemptive Right Entitlement for Dividend, Bonus Shares and Other Such Rewards

10. Benefits of Equity Shares Basic for Capital Structure Better Solvency Gestation Period No Redemption No Charge on Assets No Shopping for Credit Rating Evaluation of Share Value Better Image Creation of Value Public Knowledge of Financial Information

11. Demerits of Equity Shares Tax Implication Management Control High Rates of Dividend Lack of Flexibility Stringent SEBI Norms Huge Issue Expenses High Volatility in the Stock Market Speculation Complex Shareholder- Management Relation Rigid Corporate Governance

12. Trading on Equity Trading on Equity is, "the use of borrowed funds or preferred stock for financing” -Guthmann & Dougal

13. 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

14. Preparation of Statement of Income Leverages: Operating Leverage, Financial Leverage and Combined Leverage Degree of Leverages Significance of Each Leverage: -Sales-EBIT-EPS Relation -Measurement of Risk Levels -Behaviour of Costs

15. Proforma of a Statement of Income

16. Computation of Earning per Share

17. Problem No.1 Show 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

18. 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

19. 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

20. 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

21. Combined/Total Leverage It 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

22. Determination of Operating Leverage (OL)

23. Determination of Financial Leverage (FL)

24. Determination of Combined Leverage

25. 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

26. 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).

27. 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?

28. 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)

29. Problems------------5 Calculate DOL, DFL,DCL for the three firms from the data given below and interpret the results P Q R Output(units) 3 lakh 75,000 5 lakh Fixed Cost(Rs)3.5lakh 7lakh 75,000 VC/Unit (Rs) 1.00 7.50 0.10 Interest (Rs)25,000 40,000 - Price/Unit (Rs) 3.00 25.00 0.50 (June,2005)

30. 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 price Also has an impact on the valuation of shares Also decides the profit retained in the firm

31. Factors Affecting the Dividend Policy Corporate Policy Stable earnings Liquidity of the Corporate Past dividend Rates Present Projects Market Expectation Taxation Legal restriction Bonus Needs Investment Opportunities Restrictions of FIs Nature of Business Cost of Capital Phase of Trade Cycle Acc.Reserves Growth Needs

32. Types of Dividend Policies Stable Dividend Policy Stable Dividend Pay-Out Policy

33. Stable Dividend Policy The percentage of Dividend is kept stable The increase in percentage is only moderate over a long period of time Stable Image for the Corporate Stability in the market price Easy management of liquidity Helps in Building up the Reserves Easy maintenance of the Rate over a long period

34. Stable Dividend Pay-Out Policy A certain percentage of the surplus profit is distributed year after year Higher surplus results in a higher percentage Shareholders enjoy during periods of growth and prosperity and suffer during recession Fluctuating market Price Leading to Speculation in the trading in the shares

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