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Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University

Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University

After survey of existing literature and before preceding to analysis, it is considered a pre-requisite to have theoretical discussion on financial and capital of ,structure as well as some of the crucial ratios explaining the same. The theoretical discussion is within the scope of this chapter, and ratio analysis is within the scope of next chapter.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University

Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University

Financial management is as much concerned with the-control of liabilities and shareholder’s equity as with the control of assets. The liabilities and shareholder’s equity are the sources of assets and these two aspects of financial management are extremely interrelated. Capital structure refers to the mix of long-term sources of funds i.e. debenture, long-term debt, preference share ‘capital and equity share capital including reserves and surpluses. Decisions must be made about the kinds and amounts of assets that must be acquired and  maintained, but such decisions must be sound about the source from which the assets will be sought. Not only  the wise selection and administration of assets but the judicious selection of sources are also required in the success of management. A company should have the right  kind and amount of assets to run in each _and every conditions. Some companies do .not plan their capital structure and it develops as a result of the financial decisions taken by the financial manager without any formal planning. These companies may prosper in the short-fun, but ultimately they may suffer considerable difficulties in raising funds to finance their activities without planning of capital structure. These companies may fail to maximize the use of their funds.Consequently, it is being increasingly realised that a company should plan its capital structure to maximize the use of the funds and it should be flexible to adoptany changes more easily with the changing conditions.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

Essential Features of a Sound Capital Mix

 A sound or an appropriate capital structure should have the following essential features:

 (i)         Maximum possible use of leverage.

 (ii)        The capital structure should be flexible.

 (iii)       To avoid undue financial/business risk with the increase of debt.

 (iv)       The use of debt should be within the capacity of a firm. The firm should be in a position to meet its obligation in paying the loan and interest charges as and when due.

(v)               It should involve minimum possible risk of loss of control.

(vi)             It must avoid undue restrictions in agreement of debt.

(vii)           The capital structure should be conservative. It should be composed of high grade securities and debt capacity of the company should never be exceeded.

(viii)         The capital structure should be simple in the sense that can be easily managed and also easily understood by the investors.

(ix)             The debt should be used to the extent that it does not threaten the solvency of the firm.

Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University

Factors Determining the Capital Structure

            The capital structure of a concern depends upon a large number of factors such as leverage or trading on equity, growth of the company, nature and size of business, the idea of retaining control, flexibility of capital structure, requirements of investors costs of floatation of new securities, timing of issue, corporate tax rate and the legal requirements. It is not possible to rank them because all such factors are of different importance and the influence of individual factors of a firm changes over a period of time. Every time the funds are needed. The financial manager has to advantageous capital structure. The factors influencing the capital structure are discussed as follows:

  1. Financial leverage of Trading on Equity: The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University
  2. Growth and stability of sales: The capital structure of a firm is highly influenced by the growth and stability of its sale. If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest repayments of debt. Similarly, the rate of the growth in sales also affects the capital structure decision. Usually greater the rate of growth of sales, greater can be the use of debt in the financing of firm. On the other hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as far as possible, debt financing in its capital structure.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University
  3. Cost of Capital. Every rupee invested in a firm has a cost. Cost of capital refers to the minimum return expected by its suppliers. The capital structure should provide for the minimum cost of capital. The main sources of finance for a firm are equity, preference share capital and debt capital. The return expected by the suppliers of capital depends upon the risk they have to undertake. Usually, debt is a cheaper source of finance compared to preference and equity capital due to (i) fixed rate of interest on debt: (ii) legal obligation to pay interest: (iii) repayment of loan and priority in payment at the time of winding up of the company. On the other hand, the rate of dividend is not fixed on equity capital. It is not a legal obligation to pay dividend and the equity shareholders undertake the highest risk and they cannot be paid back except at the winding up of the company and that too after paying all other obligations. Preference capital is also cheaper than equity because of lesser risk involved and a fixed rate of dividend payable to preference shareholders. But debt is still a cheaper source of finance than even preference capital because of tax advantage due to deductibility of interest. While formulating a capital structure, an effort must be made to minimize the overall cost of capital.
  4. Minimisation of Risk: A firm’s capital structure must be developed with an eye towards risk because it has a direct link with the value. Risk may be factored for two considerations: (a) the capital structure must be consistent with the business risk, and (b) the capital structure results in certain level of financial risk. Business risk may be defined as the relationship between the firm’s sales and its earnings before interest and taxes (EBIT). In general, the greater the firm’s operating leverage – the use of fixed operating cost – the higher its business risk.  Although operating leverage is an important factor affecting business risk, two other factors also affect it – revenue stability and cost stability.  Revenue stability refers to the relative variability of the firm’s sales revenue.  Firms with highly volatile product demand and price have unstable revenues that result in high levels of business risk.  Cost stability is concerned with the relative predictability of input price.  The more predictable and stable these inputs prices are, the lower is the business risk, and vice-versa. The firm’s capital structure directly affects its financial risk, which may be described as the risk resulting from the use of financial leverage.  Financial leverage is concerned with the relationship between earnings before interest and taxes (EBIT) and earnings per share (EPS).  The more fixed-cost financing i.e., debt (including financial leases) and preferred stock, a firm has in capital structure, the greater its financial risk.
  5. Control: The determination of capital structure is also governed by the  management desire to retain controlling hands in the company. The issue of equity share involve the risk of losing control. Thus in case the company is interested in – retaining control, it should prefer the use of debt and preference share capital to equity share capital. However, excessive use of debt and preference capital may lead to loss of control and other bad consequences.
  6. Flexibility: The term flexibility refers to the firm’s ability to adjust its capital structure to the requirements of changing conditions. A firm having flexible capital structure would face no difficulty in changing its capitalization or source of fund. The degree of flexibility in capitals structure depends mainly on (i) firm’s unused debt capacity, (ii) terms of redemption (iii) flexibility in fixed charges, and (iv) restrictive stipulation in loan agreements.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

If a company has some unused debt capacity, it can raise funds to meet the sudden requirements of finances. Moreover, when the firm has a right to redeem debt and preference capital at its discretion it will able to substitute the source of finance for another, whenever justified. In essence, a balanced mix of debt and equity needs to be obtained, keeping in view the consideration of burden of fixed charges as well as the benefits of leverages simultaneously.

  1. Profitability: A capital structure should be the most profitable from the point of view of equity shareholders. Therefore, within the given constraints, maximum debt financing (which is generally cheaper) should be opted to increase the returns available to the equity shareholder.
  2. Cash Flow Ability: The EBIT – EPS analysis, growth of earnings and coverage ratio are very useful indicator of a firm’s ability to meet its fixed obligations at various levels of EBIT. Therefore, an important feature of a sound capital structure is the firm’s ability to generate cash flow to service fixed charges.

At the time of planning the capital structure, the ratio of net cash inflows to fixed charges should be examined. The ratio depicts the number of times the fixed charges commitments are covered by net cash inflows. Greater is this coverage, greater is this capacity of a firm to use debts an other sources of funds carrying fixed rate of interest and dividend.

  1. Characteristics of the company: The peculiar characteristics of a company in regards to its size, nature, credit standing etc. play a pivotal role in ascertaining its capital structure. A small size company will not be able to raise long-term debts at reasonable rate of interest on convenient terms. Therefore, such companies rely to a significant extent on the equity share capital and reserves and surplus for their long-term financial requirements.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

In case of large companies the funds can be obtained on easy terms and reasonable cost by selling equity shares and debentures as well. Moreover the risk of loss of control is also less in case of large companies, because their shares can be distributed in a wider range. When company is widely held, the dissident shareholders will not be able to organize themselves against the existing management, hence, no risk of loss of loss of control. Thus, size of a company has a vital role to play in determining the capital structure.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

The various elements concerning variation in sales, competition with other firms and life cycle of industry also affect the form and size of capitals structure. If company’s sales are subject to wide fluctuations, it should rely less on debt capital and opt for conservative capitals structure. A company facing keen competition with other companies will run the excessive risk of not being able to meet payments on borrowed funds. Such companies should place much emphasis on the use of equity than debt, similarly, if a company is in infancy stage of its life cycle, it will run a high risk of mortality. Therefore, companies in their infancy should rely more on equity than debt. As a company grows mature, it can make use of senior securities (bonds and debentures).

Capital Structure of a New Firm : The capital structure a new firm is designed in the initial stages of the firm and the financial manager has to take care of many considerations.  He is required to assess and evaluate not only the present requirement of capital funds but also the future requirements.  The present capital structure should be designed in the light of a future target capital structure. Future expansion plans, growth and diversifications strategies should be considered and factored in the analysis.

Capital Structure of an Existing Firm: An existing firm may require additional capital funds for meeting the requirements of growth, expansion, diversification or even sometimes for working capital requirements.  Every time the additional funds are required, the firm has to evaluate various available sources of funds vis-à-vis the existing capital structure. The decision for a particular source of funds is to be taken in the totality of capital structure i.e., in the light of the resultant capital structure after the proposed issue of capital or debt.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

Evaluation of Proposed Capital Structure : A financial manager has to critically evaluate various costs and benefits, implications and the after-effects of a capital structure before deciding the capital mix. Moreover, the prevailing market conditions are also to be analyzed. For example, the present capital structure may provide a scope for debt financing but either the capital market conditions may not be conducive or the investors may not be willing to take up the debt-instrument. Thus, a capital structure before being finally decided must be considered in the light of the firm’s internal factors as well as the investor’s perceptions.Unit III Capital Structure for Financial Management and Policy MCOM sem 2 Delhi University.

Profitability and Capital Structure: EBIT – EPS Analysis

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