CHAPTER 3 – CAPITAL STRUCTURE & CAPITALIZATION

MEANING OF FINANCE

Finance is defined as the provision of money at the time when it is required. Every enterprise, whether big,
medium, small, needs finance to carry on its operations and to achieve its target. In fact, finance is so
indispensable today that it is rightly said to be the blood of an enterprise.
Without adequate finance, no enterprise can possibly accomplish its objectives.

LONG TERM FINANCE

The primary goal of financial management is ‘maximization of shareholders’ wealth’. Hence, all decisions of
management are directed towards such wealth maximization. There are three basic functions of financial
management, viz. investment decisions, financing decisions and dividend decisions.

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc.
These assets may be regarded as the foundation of a business. The capital required for these assets is called
fixed capital. Funds required for long term fixed capital is called long term finance.

FEATURES OF LONG-TERM FINANCE

 It involves financing for fixed capital required for investment in fixed assets
 It is obtained from Capital Market
 Long term sources of finance have a long term impact on the business
 Generally used for financing big projects, expansion plans, increasing production, funding operations.

PURPOSES OF LONG-TERM FINANCE

1. To finance Fixed Assets – Business requires fixed assets like machines, building, furniture etc. Finance
required to buy these assets is for a long period, because such assets are used for long period.

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2. To finance the Permanent Working Capital – Business is a continuing activity. It must have a certain
amount of working capital which would be needed again and again. This part of working capital is of a
fixed or permanent nature. This requirement is also met from long term funds.
3. To finance Growth and Expansion of business – Expansion of business requires investment of a huge
amount of capital permanently or for a long period.

FACTORS DETERMINING LONG TERM FINANCE

a) Nature of Business – The nature of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So, it has to invest a large amount of capital for a long
period. But a trading firm will require a smaller amount of longterm fund as it does not have to buy
building or machines. Also, a service-oriented firm will not require much long-term funds.
b) Nature of goods produced – If a business is engaged in manufacturing small and simple articles it will
require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy
consumer items like cars, refrigerators etc. which will require more fixed capital.
c) Technology used – In heavy industries like steel the fixed capital investment is larger than in the case of
a business producing plastic jars using simple technology or using labour intensive technique.

COST OF CAPITAL

 Cost of Capital can be defined as the minimum rate of return that a firm must earn on its investments, so
that the market value of the firm is constant.
 It is the cut-off rate for determining future benefits (cash flows) against current investments.
 The decision regarding feasibility of a project is taken on the basis of cost of capital.
 Hence, cost of capital is the cost of obtaining funds from various sources. Thus, cost incurred by a
company for obtaining funds is the minimum rate of return that it must earn.
 It can be stated as the opportunity cost of an investment, i.e. the rate of return that a company would
otherwise be able to earn at the same risk level as the investment that has been selected.

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 John J. Hampton defined “Cost of capital is the rate of return the firm required from investment in
order to increase the value of the firm in the market place”
 According to Ezra Solomon “Cost of capital is the minimum required rate of earnings or the cut-off
rate of capital expenditure”.
 James C. Van Horne defined it as “a cut-off rate for the allocation of capital to investment of projects.
It is the rate of return on a project that will leave unchanged the market price of the stock”.
 According to William and Donaldson, “Cost of capital may be defined as the rate that must be earned
on the net proceeds to provide the cost elements of the burden at the time they are due”.

IMPORTANCE OF COST OF CAPITAL

 Securities analysts use Cost of Capital in valuation and selection of investments.

 In discounted cash flow analysis, Cost of Capital is used as the discount rate applied to future cash
flows for deriving a business’s net present value. It is an important constituent in Capital Budgeting
decisions.
 It also plays a key role in Economic Value Added (EVA) calculations. Used for deciding debtequity
mix.
 Investors use Cost of Capital as a tool to decide whether or not to invest. It is known as
‘Hurdle Rate’
 Cost of Capital represents the minimum rate of return at which a company produces value for its
investors.
 Cost of Capital is used for evaluating investments plans, discounting cash flows, compare with ROI.
 Weighted Average Cost of Capital is the outcome of the relative proportions of different sources of
finance.

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TYPES OF COST OF CAPITAL

a) Explicit and Implicit Cost

Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return
associated with the best investment opportunity for the firm and its shareholders that will be forgone if
the projects presently under consideration by the firm were accepted. In other words, implicit costs refer
to the opportunity cost.

b) Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the
company. It considers weighted average cost of all kinds of financing such as equity, debt, retained
earnings etc. Marginal cost is the weighted average cost of new finance raised by the company. It is the
additional cost of capital when the company goes for further raising of finance.

c) Historical and Future Cost

Historical cost is the cost which has already been incurred for financing a particular project. It is based
on the actual cost incurred in the previous project. Future cost is the expected cost of financing in the
proposed project. Expected cost is calculated on the basis of previous experience.

d) Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific
cost of capital. It is very useful to determine the each and every specific source of capital. The composite
or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of
capital. It is used to understand the total cost associated with the total finance of the firm.

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FACTORS DETERMINING COST OF CAPITAL

1. General Economic Conditions – Economic conditions determine the demand and supply of funds
within the economy, as well as expected inflation. Any change in demand and supply of money in the
economy changes the interest rates. Thus, if demand for money increases without much increase in
supply, there will be rise in interest rate and vice versa.

2. Market Conditions – Where risk increases, an investor requires a higher rate of return. Such increase is
called a risk premium. When investors increase their required rate of return, the cost of capital rises
simultaneously. The rate of return also depends on the ease of marketability of securities.

3. Operating and Financing Decisions – Various decisions of a company creates different levels of risk.
Such risk is divided into two types: business risk and financial risk. As business risk and financial risk
increase or decrease, the investor’s required rate of return (and the cost of capital) will move in the same
direction.

4. Amount of Financing – Cost of funds depends on the level of financing that the firm requires. As the
fund requirements is higher, the cost of capital increases due to additional flotation costs, legal
compliances, underwriting commission, brokerage etc.

5. Controllable Factors
a. Capital Structure Policy (Debt-Equity ratio) – A firm can control its debt-equity ratio, and it
targets an optimal capital structure. As more debt is issued, the cost of debt increases, and as more
equity is issued, the cost of equity increases.
b. Dividend Policy – A company can control its dividend payout ratio. For example, as the payout
ratio of the company increases, more the cash outflow and additional need for funds is created.
c. Investment Policy – Generally, while taking investment decisions, a company is making
investments with similar degrees of risk. If a company changes its investment policy relative to its
risk, both the cost of debt and cost of equity change.

6. Uncontrollable Factors
a. Interest Rates – The level of interest rates will affect the cost of debt and, potentially, the cost of
equity. For example, when interest rates increase the cost of debt increases, which increases the cost
of capital.

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 b. Tax Rates – Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt
decreases, decreasing the cost of capital.
c. Inflation Rates – The rate of inflation affects purchasing power, and thus affects cost of capital.

MEASUREMENT OF COST OF CAPITAL

a) Cost of Debt Capital (‘Kd’)

 Basically, debt capital represents long term borrowing of a company.
 Borrowings include Debentures and funds obtained from financial institutions, banks, Government
etc.
 The period of borrowing is fixed and the rate of interest is also fixed. Interest payment is mandatory
i.e. payable even in case of losses.
 However, interest is tax deductible, i.e. tax shield is available on interest payments.

Cost of Term Loans (Kd) = Interest (1 – tax rate) * 100

Net Proceeds
15 (1-0.2) = 15*.8 = 12%
Issue Price = Rs. 2,50,000
Interest Rate = 12%
Tax Rate = 30%

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Debentures:
 Debentures are issued by companies to the public and financial institutions.
 Debentures can be classified as irredeemable & redeemable. Irredeemable debentures are not
redeemable during life of company, whereas redeemable debentures are redeemed at maturity.
 The rate of interest is fixed, and it is paid on its face value.
 Interest attracts tax benefits and it is payable even in case of losses.
 Debentures can be issued at par, premium or discount as well as redeemed at par, premium or discount.
 Based on issue and redemption value, the net proceeds received at maturity value paid will changes
accordingly.
Cost of Irredeemable Debentures (Kd) = Interest (1 – tax rate) * 100
Net Proceeds
Cost of Redeemable Debentures (Kd) = Interest (1 – tax rate) + (RV – NP) / N*100
(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue
N = Life of redeemable debt.

= 15 (1-0.2) + (1,10,000 – 1,00,000)/10 *100

(1,10,000 +1,00,000)/2

= 12,000 + 1,000 x 100

1,05,000 =
12.38%

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b) Cost of Preference Share Capital (‘Kp’)
 Preference shares are issued to promoters, venture capitalist who invest in the company in its initial
stages.
 Earlier preference shares could be issued with an irredeemable feature. However, after the
amendment of Companies Act, preference shares can be issued for a maximum period of 20 years.
 The rate of dividend on preference shares is fixed and dividend payment is mandatory in cases of
sufficient profits. The dividend is paid as a percent of face value of the shares.
 However, dividends paid on preference shares is a non-tax deductible expense and the company
doesn’t get any tax benefits on payment of preference dividends.
 Preference shares can be issued at par or premium, thus net proceeds changes accordingly.
 Also, redemption of preference capital may be done at par or premium, according to agreement with
preference shareholders.
Cost of Irredeemable Pref Shares (Kp) = Dividends * 100 OR Dividend * 100
Net Proceeds Mkt. Price
Cost of Redeemable Preference Shares
= Dividend + (RV – NP) / N * 100
(Kp)
(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue
N = Life of redeemable preference shares

c) Cost of Equity Share Capital (‘Ke’)

 Cost of equity shares can be defined as the rate of return expected by equity shareholders.
 Equity shares are issued to promoters, financial institutions and general public.
 Such shares can be issued at par or premium.
 Equity shares of public company are freely transferable.
 The dividend payout is not fixed, as well as rate of dividend not fixed.
 Also, dividend is a non-tax deductible expense and no tax shield is available to the company.
 The cost of equity depends purely upon the expectations of the shareholders. Shareholders’
expectations and returns are reflected in market price per share.
 Any decline in returns results in adverse share price and vice versa. Since the dividend payment is
not mandatory cost of equity shares cannot be wholly based on dividends.
 The earnings of the company also influence the share price and hence the shareholders’ expectations.

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  Thus there are manly two approaches used for computation of cost of equity, based on shareholders’
expectations, i.e. dividends and earnings, coupled with expected growth rate.

i. Dividend Price Approach: Here, cost of equity capital is computed by dividing the current
dividend by the market price per share. This dividend price ratio expresses the cost of equity
capital in relation to what dividend the company should pay to attract investors. However, this
method cannot for units suffering losses.

Cost of Equity (Ke) = DPS1 * 100

MP0
Ke = Cost of equity
DPS1 = Annual dividend
MP0 = Current Market Price per equity share

ii. Dividend Price Growth Approach: Earnings and dividends do not remain constant and the price
of equity shares is also directly influenced by the growth rate in dividends. Where earnings,
dividends and equity share price all grow at the same rate, the cost of equity capital may be
computed as follows:
Cost of Equity (Ke) = (DPS1 * 100) + g
MP0

Where, g = annual growth rate of earnings of dividend

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 iii. Earning / Price Approach: According to this approach, the earnings of the company have a
direct impact on the market price of its share. Accordingly, the cost of equity share capital would
be based upon the expected rate of earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed or not from the company in whose
shares he invests.

Cost of Equity (Ke) = EPS1 * 100

MP0
Where, Ke = Cost of equity EPS1 = Earnings per share MP0 = Current Market price / equity share

iv. Earnings Price Growth Approach: When earnings increase every year, it influences the market
price per share, and the same is considered in this approach. Since, dividends are recommended
by the Board of Directors and shareholders cannot change it. Thus, this approach concentrates on
the actual strength of the company, i.e. its earnings. So, cost of equity will be given by:

Cost of Equity (Ke) = (EPS1 * 100) + g

MP0

d) Cost of Retained Earnings (‘Kr’)

Cost of Retained Earnings or Reserves & Surplus are generally taken as the same as Cost of Equity. This
is because reserves and surplus is the opportunity cost of dividends foregone by the shareholders. It is
the rate of return, which the existing shareholders can obtain by investing the dividends in alternative
options.

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e) Weighted Average Cost of Capital (WACC)
 WACC denotes the Weighted Average Cost of Capital. It is defined as the Overall Cost of Capital
computed by reference to the proportion of each component of capital as weights. It is denoted by
Ko.
 WACC is the average cost of various sources of financing, i.e. cost of its capital structure.
 The proportion of the sources of finance forms the weights. The weights can be allotted using the
book value or market value. After-tax cost of the sources of finance is considered.
 Hence WACC = Sum of [Cost of Individual Components X Proportion i.e. Capital]
The following format may be adopted for computation of WACC:

Component Amount Proportion Individual Multiplication (Ki *

(%) Cost Wi)
Debt Wl Kd Kd * W1

Preference Capital W2 Kp Kp * W2

Retained Earnings W3 Ke Kr * W3

Equity Capital W4 Ke Ke * W4

Total 1.00 Ko = WACC = Total of above

Advantages of market values as weights:

a. Market values represent the opportunity cost.
b. It represents the present economic value of various sources of finance.
c. It is consistent with the definition of cost of capital i.e. the cost of capital is the minimum rate of
return needed to maintain the market value of the firm
d. Market value is the true reflection of the firm’s capital structure.

Disadvantages of market values as weight

a. Market values are not available in case of unlisted companies.
b. It is not reliable when shares are not actively traded (no purchase or sale of share)
c. Market price fluctuates frequently and is affected by speculations. (Manipulation of share prices)

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 Advantages of using book values as weight
a. The data is easily available i.e. the Balance Sheet data.
b. Calculations are simple
c. Fewer fluctuations in Book Value.
d. Useful when Mkt. price is not available, (unlisted company) or when the shares are not actively
traded,

Disadvantages of Book values as weights

a. Affected by accounting policies.
b. Does not truly represent the opportunity cost of capital.
c. Does not represent the present economic values of various sources of finance.

MARGINAL COST OF CAPITAL

 Marginal Cost of Capital (MCC) is the cost of additional capital introduced in the capital structure.
 MCC is the differential cost of capital between original capital structure and revised capital structure.
 It is derived when the average cost of capital is computed with marginal weights. The weights
represent the proportion of funds the firm intends to employ.
 When funds are raised in the same proportion as at present and if the component costs remain
unchanged, there will be no difference between average cost of capital and marginal cost of capital.
 As the level of capital employed increases, the component costs may start increasing. In such a case,
both the WACC and marginal cost of capital will increase. But marginal cost of capital will rise at a
faster rate.

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LIMITATIONS OF COST OF CAPITAL (WACC)
The determination of cost of capital suffers with a number of problems. Conditions are continuous changing
in the modern world, i.e. present conditions today may not remain static in future. Therefore, cost of capital
which is determined today, is dependent on certain conditions or situations which are subject to change. A
form shall continuous (annually) re-examine its cost of capital before determining annual capital budget.

Following are reasons for monitoring cost of capital –

 The firms’ internal structure and character change. For instance, as the firm grows and matures, its
business risk may decline resulting in new structure and cost of capital.
 Capital market conditions may change, making either debt or equity more favourable than the other.
 Demand-Supply funds may vary from time to time leading to change in cost of different capital
components.
 The company may experience subtle change in capital structure because of retained earnings unless
its growth rate is sufficient to call for employment of debt on a continuous basis.

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EXAMPLES FOR PRACTICE

1) Compute WACC from the following data. Explain the importance of WACC in decision making.
Source of Finance Cos % in Capital
t Structure
Equity Share 16 15 %

Capital %

Preference Capital 13 10 %
%
Debentures 12 35 %
%
Term Loan 14 15 %
%
Retained Earnings 16 25 %
%
2) A company paid dividend of Rs. 3.00 in previous year. Current market price of equity share is Rs. 30.
Dividends are expected to grow at 10% p.a. The company has 10% Bank Loan (10 years tenure). Tax
rate is 25%. Find cost of equity, cost of debt and overall cost of capital.
The debt component is same as equity component.

3) Gamma Ltd. has furnished the following information:

Earnings per share (EPS) Rs. 6.00 Dividend payout ratio 20%
Market price per share Rs. 40 Rate of tax 30%
Growth rate of dividend 8%
Compute Cost of Equity (Ke)

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 4) YZ Ltd., has Equity Capital Rs. 50,00,000. Equity shares of the company are sold at Rs. 25 per share
in the market. It is expected that the company will pay next year a dividend of Rs. 4
per share which will grow at 8% forever. Assume a tax-rate of 30%. Compute Ke
5) Calculate the WACC using Book values given below. The tax rate applicable is 30%.
Source of Finance Book Value Cost
(Rs) %
Equity Capital 100,000 16.0%
14 % Preference 50,000 14.0%
Capital
Retained Earnings 50,000 16.0%
14 % Debentures 100,000 14.0%
12% Term Loan 100,000 12.0 %
6) XYZ issues, 2000 10% Preference shares of Rs 100 each at Rs 95 each. The company proposes to
redeem the preference shares at the end of the 10th year from the date of issue. Calculate the cost of
preference shares.

7) A Company issued 10,000, 10% Debentures of Rs 100 each at a premium of 10% on 01.04.2020 to be
matured on 01.04.2025. The debentures will be redeemed on maturity. Compute the cost of debentures
assuming 35% tax rate.

8) A Company issued 20,000, 12% Debentures of Rs 100 each at a premium of 20% on 01.04.2020 to be
matured on 01.04.2025. The debentures will be redeemed at 10% premium on maturity. Compute the
cost of debentures assuming 30% tax rate.

9) X Ltd. issued 15% irredeemable debentures. The par value is Rs. 100 and premium of 15% on issue.
The rate of tax is 30%. Find Kd.

10)XYZ Ltd. Issued 2000, irredeemable 10% preference shares of Rs 100 each at Rs 95 each.
Calculate the cost of preference shares.

11)ABC Ltd. Issued 2000, irredeemable 12% preference shares of Rs 100 each at Rs 110 each. Calculate
the cost of preference shares.

12)KP Ltd. Issued 5000, irredeemable 15% preference shares of Rs 100 each at Rs 100 each with
floatation cost of 3%. Calculate the cost of preference shares.

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 13)A Company has paid dividend of Rs 1 per share (FV Rs 10 per share) last year and is expected to grow
@10% next year onwards. Calculate the cost of equity if the market price of the share is Rs 55.

14)Face value of the equity shares of a company is Rs 10 while the current market price is Rs 200 per
share. Company is going to start a new project, and is planning to finance it partially by new issue and
partially by retained earnings. You are required to calculate the cost of equity shares.

15)Calculate the Ko using Market value proportions. Following data is available –

Source of Finance Mkt. Value (Rs) Cost
%
Equity Capital 60,00,000 18.0%
11% Preference 2,00,000 14.5%
Capital
13.5% Debentures 8,00,000 12.7%
18% Term Loan 10,00,000 12.6 %
Total 80,00,000
INTRODUCTION TO CAPITAL STRUCTURE

 Financing decision relates to the composition of relative proportion of various sources of finance. A
Financial Manager compares the merits and demerits of different sources of finance while taking the
financing decision.
 A business can be financed from either the shareholders’ funds or borrowings from outside agencies.
 Shareholders’ funds include equity share capital, preference share capital and accumulated profits.
Equity has no fixed commitment regarding payment of dividend or principal amount and therefore, no
risk is involved.
 Borrowings include borrowed funds like debentures and loans from financial institutions. The borrowed
funds have to be paid back with interest and some amount of risk is involved if the principal and interest
is not paid.
 Finally, it is the decision of the business to decide the ratio of borrowed funds and owned funds.
However, most of the companies use a combination of both the shareholders’ funds and borrowed funds.
 Whether the companies choose shareholders’ funds or borrowed funds, each type of fund carries a cost.
Borrowed funds involve interest payment whereas equities, as such do not have any fixed obligation but
definitely they involve a cost. Both types of funds incur cost and this is the cost of capital to the
company.

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Meaning – Capital Structure refers to the mix of sources from where the long-term funds required in a
business may be raised. In other words, it refers to the proportion of debt, preference capital and equity
capital.
According to Gerstenberg, “Capital Structure of a company refers to composition or make up of its
capitalization and it includes all long-term capital resources”.
James C. Van Horne defines capital structure as “The mix of a firm’s permanent long-term financing
represented by debt, preferred stock and common stock equity”.

Optimum Capital Structure

One of the basic objectives of financial management is to maximise the value or wealth of the firm. Capital
Structure is optimum when the firm has a combination of equity and debt so that the wealth of the firm is
maximised. At this level, cost of capital is minimum and market price per share is maximum. Hence, factors
considered in determining capital structure include nature of industry, risk element, dilution of control, cost
factor, earnings capability, Govt. policies etc.

FEATURES OF APPROPRIATE CAPITAL STRUCTURE

The following are the major features of an appropriate capital structure:

1. Profitability. It should minimize the cost of financing and maximise earning per equity share.
2. Flexibility: The capital structure should be such that company can raise funds whenever needed.
3. Conservation: The debt content should not exceed the maximum which the company can bear.
4. Solvency: The capital structure should be such that the firm does not run the risk of becoming insolvent.
5. Control: There should be minimum risk of loss or dilution of control of the company.

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PRIMARY CONSIDERATIONS IN CAPITAL STRUCTURE PLANNING
The three major considerations in Capital Structure Planning are: Risk, Cost and Control. A comparative
analysis is given:

Cost of Capital

Capital Structure Decision Risk Involved

Dilution of Control

Type of Risk Cost Control

fund

Equity Low Risk - no question of Most expensive - Dilution of control - Since

Capital repayment of capital dividend expectations of the Capital base might
except when the shareholders are higher be expanded and new
company is under than interest rates. shareholders/ public are
liquidation - Hence best Dividends are not tax- involved.
from viewpoint of risk. deductible.

Preference Slightly higher risk when Cheaper cost than Equity No dilution of control
Capital compared to Equity but higher than Interest since voting rights is
Capital -Principal is rate on loan funds. restricted.

redeemable after a certain Further, preference

period even if dividend dividends are not
payment is based on profits. taxdeductible.

Loan Funds High risk - Capital should Comparatively Cheaper No dilution of control - but
be repaid as per agreement; prevailing interest rates are some financial institutions
Interest should be paid considered only to the may insist on nomination of
irrespective of performance extent of after tax impact. their representatives in the
or profits. Board of Directors.

FACTORS AFFECTING STRUCTURE PLANNING

In addition to Risk, Cost and Control, the other considerations in Capital Structure Planning are as under:
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1. Profitability (Valuation): A degree of profitability is conducive to higher borrowings. If an
organization is confident about its profit stability they may prefer debt capital. It helps in increasing EPS
and hence positive impact on the market price per share, thereby maximizing shareholders’ wealth.

2. Corporate Taxation: Interest on borrowed capital is a tax-deductible expense, but dividend is not. Also,
the cost of raising finance through borrowing is deductible in the year in which it is incurred. If it is
incurred during the pre-commencement period, it is to be capitalized. Due to the tax saving advantage,
debt has a cheaper effective cost than preference or equity capital. The impact of taxation should be
carefully analysed.

3. Trading on equity: When the Return on Total Capital Employed (ROCE) is more than the rate of
interest on borrowed funds or the rate of dividend on preference shares, financial leverage can be used
favourably to maximise EPS. In such a case, the company is said to be “trading on equity”. Loans or
Preference Shares may be preferred in such situations. The effect of financing decision on EPS and
ROE should be analysed.

4. Cash Flow policy: While making a choice of the capital structure the future cash flow position should
be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot
of cash is needed in order to make payment of interest and refund of capital.

5. Government policies: Raising finance by way of borrowing or issue of equity is subject to policies of
the Government and its regulatory bodies like SEBI, RBI etc. The monetary, fiscal
and lending policies, as well as rules and regulations stipulated from time to time by these bodies have
to be complied with for acquiring funds through the particular mode.

6. Legal requirements: The applicable legal provisions should be considered while deciding the capital
structure. Provisions relate to maximum borrowings, approvals required for foreign direct investment
etc.

7. Marketability: The mode of obtaining finance depends on the marketability of the company’s shares or
debt instruments (debentures / bonds). In case of restrictions in marketability, it is difficult to obtain
public subscription. Hence, the company has to consider its ability to market corporate securities.

8. Size of the Company: Small companies rely heavily on owner’s funds, while large and widely held
companies are generally considered to be less risky by the investors.

9. Flexibility: Flexibility is required to have as many alternatives as possible at the time of expanding or
contracting the requirement of funds. It enables use of proper type of funds available at a given time and
also enhances the bargaining power when dealing with prospective suppliers of funds. It also implies the
capacity of business to adjust to expected and unexpected changes in the business environment.

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10. Timing: Proper timing of a security issue often brings substantial savings because of the dynamic nature
of the capital market. Hence the issue should be made at the right time so as to minimise effective cost
of capital. The management should constantly study the trend in the capital market and time its issue
carefully.

11. Purpose of financing: Funds required for long term productive purposes like manufacturing, setting up
new plant etc. may be raised through long term sources. But if funds are required for non-productive
purposes, like welfare facilities to employees such as schools, hospitals etc., internal financing may be
used.

12. Period of finance: Funds required for medium and long-term periods say 8 to 10 years may be raised
by way of borrowings. But if the funds are for permanent requirement, it will be better to issue of equity
shares.

13. Nature of investors: Enterprises which enjoy stable earnings and dividend with a proven, track record
may go for borrowings, since they are having adequate profits to pay fixed interest charges. But
companies, without assured income should prefer internal resources to a large extent since it may be
difficult to attract investors towards the issue.

14. Floatation Costs: Floatation costs are expenses incurred while issuing securities (e.g. shares,
debentures). These include commission of underwriters, brokerage, stationery expenses, etc. Generally,
the cost of issuing debt capital is less than the share capital. This attracts the company towards debt
capital.

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 20

DISTINGUISH BETWEEN

Sr. Capital Structure Financial Structure

1. Capital structure is a mix of Financial structure is a mix of

various long term funds used long term and short term
in the business sources of funds.

2. It consists of Equity & It consists of capital structure

Preference Capital, Reserves, elements as well as Current
Long-term loans, Debentures
Liabilities

3. Capital structure is a core Financial structure is the entire

element of the financial source of funds.
structure.
4. It is possible that there are long It is unlikely that there are only
term funds but no current current liabilities and no long
liabilities. term funds.

5. Long term funds may be used Short term funds should not be
for servicing short-term used for servicing long-term
(current) assets (fixed) assets.

Sr. Pyramid Capital Structure Inverted Pyramid Capital

Structure

1. A pyramid shaped capital Such capital structure has small

structure has a large proportion component of equity capital
consisting of equity capital and and retained earnings but an
retained earnings ever increasing debt
component.

2. The cost of share capital and the All increases in capital

retained earnings of the firm is structure are made through
usually higher than the cost of debt only.
debt

3. This structure is indicative of Such a capital structure is

risk averse conservative firms highly vulnerable to collapse,
i.e. very risky
OVER CAPITALIZATION
It is a situation where a firm has more capital than its requirements. In other words, value of assets is less
than its issued share capital, and earnings (profits) are insufficient to pay dividend and interest. This situation
mainly arises when the existing capital is not effectively utilized due to fall in earning capacity of the

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 21

company and the company has raised funds more than its requirements. The chief sign of over-capitalisation
is the fall in payment of dividend and interest leading to fall in value of the shares of the company.

Causes of Over Capitalization:

 Raising more money through issue of shares or debentures than company can employ
profitably.
 Borrowing huge amount at higher rate than rate at which company can earn.
 Excessive payment for the acquisition of fictitious assets such as goodwill etc.
 Improper provision for depreciation, replacement of assets and distribution of dividends at a higher
rate.
 Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation
 Considerable reduction in the rate of dividend and interest payments.
 Reduction in the market price of shares.
 Resorting to “window dressing”.
 Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.

Remedies for Over-Capitalisation

 Company should go for thorough reorganization.
 Buyback of shares.
 Reduction in claims of debenture-holders and creditors.
 Value of shares may be reduced. This will result in sufficient funds for the company to carry out
replacement of assets.

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UNDER CAPITALIZATION

It is opposite of over-capitalisation. It is a state, where actual funds available are lower than required
warranted by its earning capacity. This situation normally happens with companies which have insufficient
capital but large secret reserves in the form of considerable inflation in the values of the fixed assets not
brought into the books.

Consequences of Under Capitalization

 The dividend rate will be higher in comparison to similarly situated companies.

 Market value of shares will be higher than value of shares of other similar companies because their
earning rate being considerably more than the prevailing rate on such securities.
 Real value of shares will be higher than their book value.

Effects of Under Capitalization

 It encourages acute competition. High profitability encourages new entrepreneurs’ entry in same type
of business.
 High rate of dividend encourages the workers’ union to demand high wages.
 Normally common people (consumers) start feeling that they are being exploited.
 Management may resort to manipulation of share values.
 Invite more government control and regulation on the company and higher taxation also.

Remedies
 Stock-split will reduce dividend per share, though EPS shall remain unchanged.
 Issue Bonus Shares as it reduces both dividend per share and the average rate of earning.
 By revising upward the par value of shares in exchange of the existing shares held by them.

Over Capitalization vis-à-vis Under Capitalization

From the above discussion it can be said that both over capitalization and under capitalisation are not good.
However, over capitalisation is more dangerous to the company, shareholders and the society than under
capitalization. Under capitalization can be handled more easily than the situation of overcapitalisation.
Moreover, under capitalization is not an economic problem but a problem of adjusting capital structure.
Thus, under capitalization should be considered less dangerous but both situations are bad and every
company should strive to have a proper capitalization.
Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 23
LEVERAGES

 The term leverage in general, refers to advantage gained for any purpose.
 Leverage is the relationship between two inter-related financial variables. These may be cost, output,
sales, EBIT, EBT, EPS etc.
 Leverage effect implies the responsiveness or influence of one financial variable over other financial
variable.
 Leverage can be defined as a percent (%) change in dependent variable as compared to the percent
change in independent variable. Magnification impact on the dependent variable is the leverage effect.
Higher the leverage, higher the risk => higher the risk, higher the return.
 Leverage means a more than proportionate outcome against a given proportionate cause. In financial
analysis, leverage is used by business firms to quantify the risk-return relationship to different
alternative capital structures. Study of leverage is essential to define the risk undertaken by the
shareholders.
 Earnings available to shareholders fluctuate on account of two risks – o Variability of EBIT - Operating
Risk arises due to variability of sales and variability of expenses.
o Variability of EPS or ROE - Financial Risk arises due to the
impact of interest charges.
 James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a
fixed cost or fixed return.
 There are three commonly used measures of leverage in financial analysis. These are:
o Operating Leverage o Financial Leverage o Combined
Leverage

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 24

OPERATING LEVERAGE

 Operating leverage is defined as the ‘firm’s ability to use fixed operating costs to magnify effects of
changes in sales on its earnings before interest and taxes.
 Operating Leverage is the relationship between contribution and EBIT, i.e. effect of change in
contribution on change in EBIT.
 A change in sales will lead to a change in profit i.e. Earnings before Interest and Taxes (EBIT).  The
effect of change in sales on EBIT is measured by operating leverage.
 Since fixed costs remain the same irrespective of level of output, percentage increase in EBIT will be
higher than increase in Sales.

Operating Leverage = Contribution

EBIT
Degree of Operating Leverage = % change in EBIT
% change in Contribution

Significance of Operating Leverage –

 Degree of Operating Leverage (DOL) measures the impact of change in sales on operating income.
Suppose the operating leverage of a firm is 2 times, it implies that 1 % change in sales will lead to 2 %
change in EBIT. Hence, if sales rises by 20%, EBIT rises by 20% X 2 = 40 %. Also, if sales decreases
by say 40%, EBIT fails by 80 %.
 The DOL depends on fixed costs, i.e. if fixed costs are higher, operating leverage is higher and vice-
versa.
 If operating leverage is high, it implies that fixed costs are high. Hence, the Break-Even Point (no
profit-no loss situation) would be reached at a higher level of sales.
 Due to the high Break-Even Point, the Margin of Safety and profits would be low. This means that the
operating risks are higher. Hence, a low operating leverage is preferred.
 A high operating leverage means that profits (EBIT) may be wiped off, even for a marginal reduction in
sales. Hence, it is preferred to operate sufficiently above Operating BEP to avoid the danger of
fluctuations in sales and profits. Operating BEP is the level of Sales where EBIT becomes ‘zero’.

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 25

FINANCIAL LEVERAGE
Financial Leverage is defined as the ability of a firm to use fixed financial charges (interest) to magnify the
effects of changes in EBIT (Operating profits), on the firm’s Earning per Share (EPS). Financial Leverage
occurs when a company has debt content in its capital structure and fixed financial charges e.g. interest on
debentures. These fixed financial charges do not vary with the EBIT. They are fixed and are to be paid
irrespective of level of EBIT. Hence an increase in EBIT will lead to a higher percentage increase in
Earnings per Share (EPS). This is measured by the
Financial Leverage, sometimes also known as ‘Financial Gearing’
Financial Leverage = EBIT
EBT
Degree of Financial Leverage = % change in EBT
% change in EBIT Significance of
Financial Leverage:
 Degree of Financial Leverage measures the impact of change in EBIT (Operating Income) on
EPS (earnings per share). Suppose, financial leverage of a firm is 4 times, it implies that 1 % change in
EBIT will lead to 4 % change in EPS. Hence, if EBT increases by 10%, EPS increases by 10% X 4 = 40
%. Also, if EBIT decreases by say 5%, EPS fall by 20 %.
 Degree of Financial Leverage depends on the magnitude of interest and fixed financial charges. If these
costs are higher, financial leverage is higher and vice-versa.
 If Degree of Financial Leverage is high, it implies that fixed interest charges are high. This means that
the financial risks are higher. The financial leverage is considered to be favourable or advantageous to
the firm, when it earns more on its total investment that what it pays towards debt capital. In other
words, financial leverage is advantageous only if Return on Capital Employed (ROCE) is greater than
Interest rate on Debt.
 Financial BEP is the level of EBIT which covers all fixed financing costs of the company.
Financial BEP is the level of EBIT at which EPS is zero.

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 26

COMBINED LEVERAGE

Combined Leverage is used to measure the total risk of a firm i.e. Operating Risk and Financial Risk. The
effect of fixed operating costs (i.e. operating risks) is measured by operating leverage. The effect of fixed
interest charges (i.e. financial risks) is measured by financial leverage. The combined effect of these is
measured by combined leverage.

Combined Leverage = Contribution

EBT

Combined Leverage = Operating Leverage (x) Financial Leverage

Degree of Combined Leverage = % change in EBT

% change in Contribution

Significance: Operating leverage measures impact of change in Sales on EBIT, Financial leverage measures
the impact of change in EBIT on EPS. Combined leverage measures the combined impact, i.e. effect of
change in Sales on EPS.

DISTINGUISH

Sr. Operating Leverage Financial Leverage

1. Operating Leverage is associated Financial Leverage is associated

with investment activities of a with financing activities of a

company. company.
2. It consists of fixed It consists of fixed interest cost of
operating expenses company
3. It measures business risk It measures financial risk
4. It shows relationship between sales
It shows relationship between EBIT and EBT
and EBIT
5. Operating leverage doesn’t involve
Financial leverage results in trading on equity.
trading on equity.

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 27

PRACTICAL QUESTIONS

1) From following data of Abhishek Ltd. as on 30 th Sept, 2006, compute the operating leverage, financial
leverage, combined leverage and percentage change in earnings per share (EPS), if sales are expected to
rise by 5%:
Earnings before interest and tax (EBIT) Rs. 10 lakhs,
Profit before Tax (PBT) Rs. 4 lakhs and Fixed Costs Rs. 6 lakhs.

2) Monark Ltd. is considering two alternative financial plans to start a new project. In Plan-I, it is likely to
issue equity shares of Rs. 16 lakhs and 13% preference capital of Rs. 4 lakhs. In Plan-II, the company
will issue equity shares of Rs. 8 lakhs, 13% preference capital of Rs. 4 lakhs, and 15% debentures of Rs.
8 lakhs. Expected EBIT is Rs. 400,000. The face value of equity shares in both plans is Rs. 10. Tax rate
is 30%. Required –  Which Plan is most suitable for the company?

3) Maxwell Ltd. generated sales of Rs. 70 lakhs and operating profits of Rs. 18 lakhs. During the year,
finance charges were Rs. 16,000 and preference dividends Rs. 20,000, the same shall continue in next
year. As a per of diversification plan, the company needs Rs. 7 lakhs, which will augment the operating
profits by Rs. 4 lakhs. Following options are available:
a) Issue 10000 ordinary shares at Rs. 70 per share. The company has existing 80000 shares
outstanding, or
b) Issue 15% Debentures of Rs. 7 lakhs with maturity of 15 years, or
c) Issue 14% Preference shares of Rs. 7 lakhs.
Assuming 30% tax rate, compute the EPS at the expected level of profits, for each financing option

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 28

4) Following two financial plans of Damn Ltd., with two financial situations. Compute all leverages for
both plans.

Installed capacity 10,000 units

Actual production and sales 60% of installed capacity
Selling price per unit Rs. 30

Variable cost per unit Rs. 20

Fixed cost: Situation A = Rs. 20,000 & Situation B = Rs. 25,000. Capital structure of company under
two plans:
Particulars Plan I Plan II

Equity Shares 10,000 40,000

12% Debt 40,000 10,000

Total 50,000 50,000

5) Given below is the Balance Sheet of Honey Ltd.

Liabilities Rs. Assets Rs.
Equity Capital (FV Rs. 180,00 Fixed Assets 450,00
10) 0 0

10% Debentures 240,00

0

Retained Earnings 60,000 Current 150,00

Assets 0

Current Liabilities 120,00

0

Total 600,00 Total 600,00

0 0

The total assets turnover ratio is 2.50 times, fixed operating costs are Rs. 200,000, variable cost ratio is
40% and income tax rate is 30%.
a) Compute Operating leverage, Financial leverage and Combined leverage

Compiled by – Prof. Onkar Pathak (CS, M. Com, NET)Page 29