4 – CAPITAL STRUCTURE AND LEVERAGE

An organisation needs capital to invest in various projects for the purpose of earning profit. It

can raise capital from various sources such as issuing equity shares, Preference shares or

debentures. The combination of different sources of capital used by an organisation to finance

its activities is known as capital structure.

In the words of C. W. Gerstenberg “ Capital structure refers to the kind of securities that

makeup capitalization”

Importance of capital structure

• a good capital structure minimises the financial risk assumed by the company

• A sound capital structure avoids over or under capitalisation

• a good capital structure maximises the value of the firm.

• A sound capital structure minimises the cost of capital.

• Capital structure helps to determine the required rate of return from the investment in

projects.

Finance Structure

Finance structure refers to the way the company’s assets are financed. This represents all

the long term sources of capital and short term sources of capital. Finance structure shows

the pattern of total financing. Capital structure is only a part of finance structure.

Determinants of capital structure

Internal factors

• Profitability

while deciding or planning capital structure the firm should keep the objective of

maximising the shareholders wealth

• Liquidity
 while planning the capital structure an important factor to be considered is

liquidity.The finance manager has to find out the expected cash inflows and cash

outflows including interest and repayment.

• Flexibility

The firm while deciding the capital structure shall ensure flexibility in the capital

structure.

• Size of business

it is very difficult for small companies to raise long term debts.

• Nature of business

Manufacturing companies require heavy investment in fixed assets. In such firms

fixed cost constitute a major portion of total cost. these firms have more risk.

trading firms assume lower risk as they operate with current assets.

• Regularity and certainty of income

debentures should be issued only when the company expects a high and regular

income. Preference shares may issue when the earnings Are irregular but fairly high.

Then earnings are uncertain and unpredictable equity shares alone should be issued.

External factors

• Conditions in the capital market

capital market conditions determine the type of securities to be issued. This

determines the rate of interest on debentures, rate of dividend on preference shares etc

• Attitude of investors

Attitude of investors is another factor which determines the securities to be issued.

• Cost of financing
 the cost of finance also exercise is an important influence upon the selection of

securities. it is desirable to employ cheapest source of finance to maximise

returns.

• Legal requirements

while determining capital structure the company should take care of the relevant

portions of various laws framed by the government from time to time.

• taxation policy

high tax rate directly influences the capital structure decision's hi tax discourages

the issue of equity shares and encourages the issue of debentures.

Optimum capital structure

Optimum capital structure simply refers to the best or most economical capital

structure.It is the mix of debt and equity that maximises the value of the company

and minimises the cost of capital. The optimum capital structure is one which

strikes a balance between risk and return and thus enhances the price of the shares.

Essentials or requisites of optimal capital structure

• Balance

There should be a balance between different types of ownership and creditorship

securities.

• Economy

the capital structure should ensure the minimum cost of issue and financing. the

financial risk should be minimum.

• Liquidity and solvency

While designing the capital structure, weightage should be given to liquidity and

solvency of the company.

• Flexibility
 The capital structure should be such that it may be possible to raise funds when

required and to repay them when they are not required.

• Simplicity

A capital structure should define clearly the rights attached to each class of

security.

• Safety

An ideal capital structure should ensure safety of investment

• Maximum return

The capital structure should be such that it may provide maximum return to equity

shareholders who are the real owners of the company.

LEVERAGE

There are two major components of capital structure of a company. They are debt

and equity. Whenever there is a change in debt equity mix, there is an impact on

the shareholder's return and risk. The effect on the shareholder's return and risk as

a result of change in the debt equity mix is known as leverage.

Leverage means relationship between two inter related variables. These variables

may be cost, output, sales revenue, EBIT, EPS etc..

Financial Leverage

The use of borrowed money to make more money is called financial leverage.

Using fixed cost capital with the equity share capital is known as financial

leverage. It is also known as capital leverage.

Importance of Financial Leverage

• Planning of capital structure

 Financial leverage is concerned with balance between debt and equity. Though it

is possible to minimise the cost of capital and maximise the return to equity share

holders.

• Profit Planning

The concept of financial leverage is important for profit planning. Profit planning

requires careful analysis of various possible levels of sales.

• Increase in shareholder's income

Higher dividend can be declared in case of favourable financial leverage. This will

increase the goodwill of the firm.

• Measurement of risk

A high degree of financial leverage indicates that the company working under a

very high risky situation. In this way, financial leverage helps to measure risk.

Limitations

• Double edged sword

• Increase risk

• Beneficial only to companies having stable earnings

• Restrictions from financial institutions

Operating Leverage
The presence of fixed cost is known as operating leverage. It measures the extent

to which fixed cost is used in operating the firm. If the fixed cost are more as

compared to variable cost, the operating leverage will be high.

Importance of Operating Leverage

• Profit planning

It is relevant for capital budgeting decisions. Capital budgeting is essential for

long term profit planning.

 Capital structure planning

OL influences the debt equity mix or capital structure planning.

Risk analysis

OL tells the impact of change in sales on operating profit of the firm.

Relationship between OL and FL

OL

• It magnifies effect of changes in sales volume on operating profit.

• It establishes relationship between operating profit and sales.

• It relates to the asset side of balance sheet

• It is concerned with investment decision

FL

• It magnifies the effect of changes in operating profit on EPS.

• It establishes relationship between operating profit and return on equity.

• It relates to the liability side of the balance sheet.

• It is concerned with financing decision.

Sources of long term finance

• Share Capital

1. Equity share capital

Equity share capital represents the contribution made

by the equity shareholders. They are the owners of

the business. Their dividend is not fixed.

2. Preference share capital

 It represents the contribution made by preference

shareholders. The dividend paid on it is fixed.

Financing through preference shares is much cheaper

than the equity shares.

• Debenture Capital

Debenture refers to borrowings. Debentures are

instruments for raising debt capital. Debenture holders

being creditors have neither voting powers nor control in

policy making. Denture holders Get day fixed rate of

interest even if the company incur losses.

• Venture capital

Venture capital refers to capital which is available for

financing new venture. it is a financial investment in a

highly risky project with the objective of earning a high

rate of return.

• Lease finance

Lease is a right to use an asset. In a lease, the owner allows

the user to use the asset for a specific period for a

consideration. does lease finance can be explained as a

 contract between the owner of the asset and the user of the

asset.

• Institutional finance

There are several financial institutions for giving financial

assistance to entrepreneurs.

Some of them are IDBI, IFCI, SIDBI, NABARD etc. All

these institution provide long term finance.

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