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Factors affecting & Essential features of Capital Structure Mix, Optimal Capital Structure(in Hindi)
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Heena Malhotra
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come back with rock series on DI concept
this lesson also clear with all point
Heena Malhotra
a year ago
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mam please ab to HRM par
  1. Capital Structure Decision By Heena Malhotra


  2. Factors affectina capital structure While choosing a suitable financing pattern, certain fundamental principles should be kept in minds, to design capital structure, which are discussed below: (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 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 earpings, of the firm. Therefore, it needs caution to plan the capital structure of a firm


  3. 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 ordeclining, it should not employ, as far as possible, debt financing in its capital structure. Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimises cost of capital structure and maximises earnings per share (EPS). For e.g. Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, whereas no such deduction is allowed for dividends. (2) (3) By Heena Malhotra


  4. Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest payout. This would lead to erosion of shareholders' value in unfavourable business situation. There (4) are two risks associated with this principle: 0 Business risk: It is an unavoidable risk because of the environment in which the firm has to operate and it is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm products, variations in prices and proportion of fixed cost in total cost. (i) Financial risk: It is a risk associated with the availability of earnings per share caused by use of financial leverage. It is the additional risk borne by the shareholders when a firm uses debt in addition to equity financing. By Heena Malhotra


  5. Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed. Issue of new equity will dilute existing control pattern and also it involves higher cost. Issue of more debt causes no dilution in control, but causes a higher degree of financial risk. (5) (6) Flexibility Principle: By flexibility it means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too. While debt could be interchanged (f the company is loaded with a debt of 18% and funds are available at 15%, it can not be available in case of equity investment. By Heena Malhotra


  6. Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the industry should also be considered. (7) r ompetion aloreser t roeityh about satisfactory compromise between the above principles. The compromise can be reached by assigning weights to these principles in terms of various characteristics of the company By Heena Malhotra


  7. 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. (ii) 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) t 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. and also easily understood by the investors. the firm (vii) The capital structure should be simple in the sense that it can be easily managed (ix) The debt should be used to the extent that it does not thre terf ehe saiventy of


  8. OPTIMAL CAPITAL STRUCTURE The theory of optimal capital structure deals with theissue of the right mix of debt and equity in the long term capital structure of a firm. This theory states that if a company takes on debt, the value of the firm increases up to a point. Beyond that point if debt continues to increase then the value of the tirm will start to decrease. Smilarly, it the company is unable to repay the debt within the specified period then it will affect the goodvill of the company in the market and may create problems for collecting further debt. Therefore, the company should select its appropriate capital structure with due consideration to the factors mentioned earlier. By Heena Malhotra


  9. Particulars EBIT Less: Interest PBT Less: Taxes PAT Less: Preference dividend Earning available to ordinary shareholders Shares outstanding EPS By Heena Malhotra