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Capital Structure-B.V.Raghunandan, SVS College,Bantwal

Bharathi College,Mangalore

September 8, 2012

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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

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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

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Features of Debt

• Compulsory Payment of Interest

• Compulsory Repayment

• Only Fixed Interest

• No Annual Reports

• No Voting Rights

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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

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Demerits of Debt• Compulsory Payment of Interest

• Solvency Affected

• Compulsory Redemption

• Charge on Assets

• Credit Rate Shopping

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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

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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

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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

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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

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DE RATIO=LONG TERM DEBT: NETWORTH

DE MIX=

Networth

TermDebtLong

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LONG-TERM DEBT=SECURED LOANS + UNSECURED LOANS

Long-Term Debt= Debentures +Bonds + Long Term Loans

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NETWORTH=SHAREHOLDERS’ FUNDS

Networth = Share Capital +

Reserves & Surplus –

Fictitious Assets

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Calculate Debt Equity Ratio of Precision Limited whose Balance Sheet as on March 31, 2004 was as given below

LiabilitiesAmount

(Rs) AssetsAmount

(Rs)

Equity Shares12% Preference SharesGeneral Reserve Profit & Loss A/c15% Mortgage DebtLoan from IDBICurrent Liabilities & Provisions

4,00,0002,00,000 50,000 50,000

15,50,0005,50,000

4,00,000

Fixed Assets

Current Assets, Loans & Advances

26,00,000

6,00,000

Total 32,00,000 Total 32,00,000

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Bentley Systems Limited had the following Balance Sheet as on 31-3-2004. Calculate Debt Equity Ratio.

LiabilitiesAmount

(Rs)Assets

Amount (Rs)

I SHARE CAPITAL; Equity Shares Pref.SharesII RESERVES & SURPLUSIII SECURED LOANSIV UNSECURED LOANSV CURRENT LIABILITIES & PROVISIONS

3,00,000 1,00,000

2,50,00010,00,000

2,00,000

50,000

I FIXED ASSETSII INVESTMENTSIII CURRENT ASSETS, LOANS & ADVANCESIV MISCELLANEOUS EXPENDITURE: Preliminary Exps Disc.on Issue of Shares Profit & Loss A/c

16,00,000 ---

2,00,000

40,000

30,000 30,000

19,00,000 19,00,000

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2.3 Calculate Debt Equity Ratio of Suryodaya Chemicals 2000-01. Comment on the variation in the debt equity ratio from the year

2000 to the year 2001.

Liabilities 2000 2001 Assets 2000 2001

Sundry CreditorsBills Payable15% DebenturesLT LoansReservesProfit & Loss A/cEquity Share Cap

78,300 61,7009,00,0006,00,000 80,2001,19,8003,00,000

89,900 30,1006,00,0008,00,0001,17,5001,82,5004,00,000

CashS.DebtorsS.AdvanceStock Land & BldPlant & Ma.Goodwill

19,4002,80,600

75,0003,48,0004,07,0008,20,0001,90,000

17,6002,62,400

60,0003,70,0005,30,0007.90.0001,90,000

21,40,000 22,20,000 21,40,000 22,20,000

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Solution for Suryodaya Chemicals 2.3

• For 2000: Long Term Debt = Deb + LT Loans

= 9,00,000 + 6,00,000= 15,00,000• Equity = Eq.Shares + P&L A/c + Reserves

= 3,00,000 + 1,19,800 + 80,200

= 5,00,000• Debt Equity Ratio = 15,00,000 : 5,00,000

= 3:1

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DE Ratio for 2001

• LT Debt = 6,00,000 + 8,00,000 = 14,00,000• Equity = 4,00,000 + 1,82,500 + 1,17,500

= 7,00,000

DE Ratio = 14,00,000 : 7,00,000 = 2:1

DE Ratio has come down due to lesser component of Debentures even though LT Loan has gone up. Every component of equity has also gone up.

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Debt Equity Mix

• Significance of a High Debt Equity Mix: Reduced Tax Liability, Higher EPS

• Significance of a Low Debt Equity Mix: Better Risk Management

• Zero Debt Capital Structure and Its Relevance

-Reducing Corporate Tax Rates

-Equity Tied Image

-Opportunity for Mergers & Acquisitions

-Other Benefits

Trading on Equity

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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

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Operating Leverage

• The presence of fixed cost in the cost structure leads to operating leverage

• A certain percentage of increase in sales results in increases percentage of increase in EBIT

• Operating Leverage is a measure that determines the number of times the EBIT goes up due to a given increase in the sales

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Significance of Operating Leverage

• Sales-Operating Profit Relation• Role of Fixed Cost• Measurement of Operating Risk

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Quantitative Significance of Operating Leverage

• A Company had an operating leverage of 3. If sales goes up by 20%, calculate the percentage of increase in EBIT.

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Calculate the operating leverage from the following details: Sales 3,750 units; Variable Cost Rs.14 per unit; Price per unit Rs.16 and Fixed Cost –Rs.4,000.

With the help of operating leverage, calculate the percentage of increase in EBIT for an increase of 10% in sales

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Hercules Products Limited presents the following details. You are required to calculate the operating leverage. Selling price per unit-Rs.10; Sales-3 lakh units; variable cost-Rs.6 per unit and fixed cost-Rs.6,00,000. Analyse the situation with an output of 4 lakh units

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Financial Leverage

• Financial leverage is the magnified impact produced on the EPS of a company for a given increase in the operating profit or EBIT.

• If a company has an operating leverage of 3, a 20% increase in EBIT will result in a 60% increase in the EPS

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Measurement of Financial Leverage

• Where there is no Preference Share

EBIT Financial Leverage= --------- EBT• Where there is preference share,

TP

EBT

EBITeverageFinancialL

1

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Statement of Income Amount

Rs.• Sales.... -------- (-) Variable Cost.. -------- Contribution -------- (-) Fixed Cost -------- Operating Profit/ (EBIT) ------- (-) Interest ------- (EBT)

(-) Tax ------- Earning After Tax (EAT) ----

• (-) Preference Dividend ---- Surplus Profit ----

• Surplus Profit• Earning Per Shares (EPS) =-----------------------

No of Equity Shares

 

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Significance of Financial Leverage

• Tool for Investment• Relation between EBIT and EPS (A Financial

Leverage of 3 means a 10% increase in EBIT will result in 30% increase in EPS)

• Measurement of Financial Risk

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Combined Leverage

• Measures the impact on EPS for a given percentage of increase in Sales

• Combined Leverage = OL X FL

• Combined Leverage = EBT

onContributi

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Significance of Combined Leverage

• Total Risk Level of the Organisaion• Measures the Relation between Sales and EPS

(A Combined Leverage of 5 means a 10% increase in Sales will result in 50% increase in the EPS)

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THANK YOU