FINANCIAL MANAGEMENT

MBASEMESTER – II

Course FacultyAmita Shivhare

CAPITAL STRUCTURE

• Capital structure• Optimum capital structure• Theories of capital structure• Features of sound capital mix• Leverage – Financial & Operating Leverage• Sources of finance

What is Capital Structure

The capital structure is made up of debt and equity securities and refers to permanent financing of a firm.

It is composed of long term debt, preference share capital and shareholder’s fund.

Capitalisation, Capital structure and Financial structure

Capitalisation is a quantitative aspect of the financial planning of an enterprise. It refers to the total amount of securities issued by a company.

Capital structure refers to the kinds of securities and the proportionate amount that makes up capitalisation

• Financial structure means the entire liabilities side of the balance sheet.

• It is composed of a specified percentage of short term debt, long term debt and shareholder’s fund.

Forms/Patterns of Capital Structure

a) Equity shares only

b) Equity and Preference shares

c) Equity shares and Debentures

d) Equity shares, Preference shares and Debentures.

Optimal Capital structure

• That capital structures or combination of debt and equity that leads to the maximum value of the firm.

• Maximises the value of the company and hence the wealth of its owners and minimises the company’s cost of capital.

Theories of Capital Structure

• Net Income Approach

• Net Operating Income Approach

• Traditional Approach

• Modigliani & Miller Approach

Net Income Approach

Assumptions of NI Approach

• The cost of debt is less than the cost of capital

• There are taxes• The risk perception of investors is not

changed by the use of debt.

Net Operating Approach

Assumptions of NOI Approach

• The market capitalises the value of the firm as a whole

• The business risk remains constant at every level of debt equity mix.

• There are no corporate taxes.

M & M Approach

Two conditions in it :

• In the absence of taxes

• When the taxes exist

Assumptions of M & M approach

• There are no corporate taxes• There is a perfect market• Investors act rationally.• The expected earnings of all the firms

have identical risk characteristics.• All earnings are distributed to the

shareholders.

Features of Sound Capital Mix

• Maximum possible use of Leverage• Capital structure should be flexible• Avoid undue Financial Risk with the

increase of debt.• Involve minimum possible risk of loss of

control• Use of debt should be within the capacity

of firm.

Leverage

Leverage refers to a relationship between two interrelated variables.

It is the % change in one variable divided by the % change in some other variable or variables.

= % change in dependent variable

% change in independent variable

Leverage

Operating Leverage Financial Leverage

Operating Leverage

• The relationship between sales revenue and EBIT is Operating Leverage.

• It measures the effect of change in sales revenue on the level of EBIT.

OL = % change in EBIT % change in Sales Revenue OL = Contribution EBIT

OL may be interpreted as follows:

OL is the % change in EBIT as a result of % change in sales. It arises as a result of fixed cost in the cost structure.

If there is no fixed cost , there will be no OL and the % change in EBIT will be same as % change in sales.

A positive DOL means a firm is operating at a level higher than the break even level and both the EBIT and Sales Revenue are in the same direction.

A negative DOL means that the firm is operating at a lower level than the break even level, and the EBIT will be negative.

Limitations Of Financial Leverage

• Double edged weapon

• Beneficial only to companies having stability of earnings

• Increases risk and rate of Interest

Financial Leverage

It measures the relationship between the EBIT and the EPS and it reflects the effect of change in the EBIT on the level of EPS.

FL = % change in EPS

% change in EBIT

Three situations for comparison

• When ROI is equal to the cost of Debt

• When ROI is less than Cost of Debt Unfavorable FL

• When ROI is more than Cost of Debt Favorable FL or Trading on Equity

FL can be interpreted as follows:

• Fl is a % change in EPs as result of & change in EBIT.

• It emerges as a result of fixed financial cost ( in the form of interest & preference dividend)

• If there is no fixed financial liability , there will be no FL.

• A positive FL means that the firm is operating at a level of EBIT which is higher than the financial break even level and both the EBIT and EPS will vary in the same direction as the EBIT changes.

• A negative FL means the firm is opearting at a level lower than the financial break even level and EPs will be negative.

Importance and Significance

Operating Leverage

And

Financial Leverage

Close Similarity b/w OL and FL

• OL appears if firm has fixed operating cost whereas FL appears when the firm has a fixed financial charges in the form of interest payment on debt financing.

• The fixed cost magnifies the effect of variability of the sales on the level of EBIT, thus OL increases the variability of the EBIT.

•

• On the other hand, the fixed financial charges magnifies the effect of variability of the EBIT on the level of EPS , thus FL increases the variability of EPS.

• FL takes over where the OL leaves off.

• The OL may be rightly called the Leverage of the first order or First stage Leverage

• FL may be called the Leverage of the second order or Second stage Leverage.

Combined Leverage

• CL is to measure the % change in EPS for a % change in Sales.

• CL is a product of both OL and FL.

• CL= OL * FL

• CL= % change in EPS % change in Sales