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Contents
Introduction to Capital Structure Trading on Equity Advantages Forms and patterns of Capital Structure Financial B.E.P E.B.I.T-E.P.S Points of indifference Optimal Capital Structure Essentials of sound Capital Structure Basic Ration Factors affecting Capital Structure Theories of Capital Structure Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory Modigliani-Miller (M-M) Theory
Introduction
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. For example, a firm that sells $30 billion in equity and $70 billion in debt is said to be 30% equity-financed and 70% debt-financed. Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations. Debt comes in the form of bond/debentures issues or long-term notes payable, while equity is classified as equity share , preference share or retained earning.
Contd.
In broader sense , Financial Structure and Capital Structure are same but, In a narrow sense: Financial structure = Long term + Short term liabilities Capital structure = Long term liabilities
Advantage
The rate of return on investment is more then the rate of interest on debt and rate of dividend on preference capital and hence the difference is distributed to share capital. The interest paid on debt is tax deductible and hence there is tax saving.
It is a critical point in planning the capital structure of the firm. If EBIT is less then Financial BEP, EPS shall be ve and hence fix interest bearing debt for preference share capital should be reduced. Forever in case the level of EBIT exceed the financial BEP, more of such fixed cost funds may be introduced in the capital structure.
Where, X = EBIT at Indifference Point I1 = Interest in Alternative 1 I2 = Interest in Alternative 2 T = Tax Rate PD = Preference Dividend S1 = No. or amount of Equity Shares in Alternative 1 S2 = No. or amount of Equity Shares in Alternative
Basic Ratio
Sound or Optimal Capital Structure requires (An Approximation):
Debt Equity Ratio: 1:1 Earning Interest Ratio: 2:1
During Depression: one and a half time of interest.
Total Debt Capital should not exceed 50 % of the depreciated value of assets. Total Long Term Loans should not be more than net working capital during normal conditions. Current Ratio 2:1 and Liquid Ratio 1:1 be maintained.
External
Capital Market Conditions
Nature of Business
Statutory Requirements
Assets Structure
Nature of Investors
Trading on Equity
Cost of Financing
Taxation Policy
Economic Fluctuations
Assumptions
Kw is constant for all degree of leverage NOI is capitalized at an overall capitalization rate to find out the total market value of the firm. Thus the split between D & E is irrelevant.
TRADITIONAL APPROACH
Cost of capital is dependent on the capital structure. The main propositions of this approach are:Cost of debt capital remains constant up to a certain degree of leverage and there after rises Cost of equity capital remains constant more or less or rise gradually up to a certain degree of leverage and thereafter increases rapidly. The average cost of capital reduces up to a certain point and remains more or less unchanged for moderate increase in leverage and there after rises after attaining a certain point.
Contd.
It accepts that capital structure of a firm affects the COC and its valuation. It does not subscribe to the concept that the value of the firm will necessarily enhance with all levels of leverage.
Propositions
COC and market value of the firm are independent of its capital structure. Cost of capital = capitalization rate of equity Total market value of the firm is determined by capitalizing the expected NOI by the rate appropriate for the risk class. Ke Kd = premium for financial risk Increased Ke is offset by the use of cheaper debt The cut off rate for investment is always independent of the way in which an investment is financed.
Criticism of MM hypothesis
Different rates of interest Corporate taxes
Contd.
The use of low cost debt enhances the risk of equity share holders, enhancing the equity capitalization rate. Thus the benefit of DEBT is nullified by the increase in the EQUITY CAPITALIZATION RATE. V = EBIT / Kw An increase in the use of debt funds is offset by an increase in the equity capitalization rate. This occurs because the equity investors seek more compensation as they are exposed to higher risk arising from increase in the degree of leverage
Sources of fund
Table of content
Introduction to sources of funds Finance types Equity shares Advantages Disadvantages Preference shares Types Features Advantages Disadvantages
Retained Earnings
Advantages of retained earnings Disadvantages Loan Financing Bridge Financing Lease Financing
Introduction
In our present day economy, finance is defined as the provision of money at the time when it is required. In fact, finances today is rightly said as the life blood of an enterprise. Capital required for a business can be classified under two main categories :Fixed Capital Working Capital
According to period
According to ownership
Owned Borrowed
Internal External
Security financing or External financing Internal financing Loan financing through raising of long-term and short-term loans
EQUITY SHARES
Equity shares, also known as ordinary shares or common shares, represent the owners capital in a company. Real owners of the company. Equity shareholders are paid dividend after paying it to the preference shareholders. Cannot be redeemed
PREFERENCE SHARES
Preference for payment of dividend
Preferences
DEFERRED SHARES
Also known as founder shares since they are issued to the founders or promoters for services. Rank last as far as payment of dividend and return of capital is concerned. According to Companies Act,1956 no public limited company or which is a subsidiary of public company can issue deferred shares
SWEAT EQUITY
Equity shares issued by a company to its employees or directors at a discount. To induce a sense of belongingness of the employee or director towards the company. To ensure more loyalty and participation of the employee. Can be issued only one year after the company is entitled to commence business
DEBENTURES
While Starting of a business the company needs large amount of investment. The company borrow funds from banks or other financial institutions. Debenture is a long term liability, these are the creditors to the company & the company pay some %age of interest to the debenture holder. Debentures are also called BONDS.
TYPES OF DEBENTURES
SIMPLE OR UNSECURED DEBENTURES REGISTERED DEBENTURES
BEARER DEBENTURES
CONVERTIBLE DEBENTURES
FEATURES OF DEBENTURES
CLAIMS ON ASSETS
ADVANTAGES OF DEBENTURES
ADVANTAGES TO THE COMPANY : Debentures provide long term funds The rate of interest payable on debentures is usually lower than the rate of dividend paid on shares. ADVANTAGES TO THE INVESTORS : Debentures provide a fixed and regular source of income to the It is comparatively a safer investment.
DISADVANTAGES OF DEBENTURES
DISADVANTAGES FOR THE COMPANY :
The fixed rate charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits. The use of debt financing usually increases the risk perception of investors in the firm . Cost of raising finance through debentured is also high because of high stamp duty.
CONTD.
CREATION OF MONOPOLIES
LOAN FINANCING
Important mode of financing
Short term loans and credits Medium loans
CONTD
Accrued expenses Deferred Incomes Commercial banks x Different forms x Loans x Cash credits x Overdrafts x Purchasing and Discounting of bills Public deposits
LOANS
Specialized financial institutions or developmental banks
Commercial banks
Loans
Seed capital:
Schemes opened by IDBI to finance the eligible entrepreneurs who lack financial capability. Specially designed for promoters to the company.
Operating schemes:
Special seed capital assistance schemes Seed capital assistance schemes
Bridge finance
To avoid delay in implementation of the project
Specifically short term loans Higher rate of interest Loan repaid when loan disbursements are received from the financial institutions.
Lease financing
Form of renting assets but the firm need not own the assets.
Basically interested in acquiring the use of asset. Firm considers leasing the assets rather than buying it.
Types of Leasing
Operating or service lease :Short term lease on a period to period basis. Cancelable at short notice by the lessee Option of renewing the lease after the expiry of lease period
Contd.
Financial lease:
Usually for a longer period and non cancelable. Lessee is responsible for the maintenance, insurance and Service of the asset and so also known as net lease.
Euro issues
Method of raising funds through foreign exchange. Issue made abroad through instruments denominated in foreign currency. Any one capital market can absorb only a limited amount of companys stock.