Capital-structure Unit III 6 3 2014 Ppt

8/17/2019 Capital-structure Unit III 6 3 2014 Ppt

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Leverage Analysis & Capital

structure

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Capital Structure Defined

• The term capital structure refers to “theproportionate relationship between debt,preference and equity shares on a firm’s

balance sheet ”.• The various means of financing represent thefinancial structure of an enterprise. The left handside of the !alance sheet "lia!ilities plus e#uity$

represents the financial structure of a company.Traditionally% short term !orro ings are e'cludedfrom the list of methods of financing the firm(scapital e'penditure

)



Planning the Firm’s Financing Mix*o do e ant to finance

our firm(s assets+

,



Balance Sheet urrent urrent

!iabilities "ssets #ebt and

Fixed"ssets

Preferred Shareholders’ $quity

-

apitalSt

r uctur e



Balance Sheet

urrent urrent"ssets !iabilities

#ebt andFixed Preferred

"ssets Shareholders’

$quity



%hy is apital Structure&mportant'

• () !e*erage+ higher financial le*eragemeans higher returns to stoc holders,but higher ris due to interest payments-

• .) ost of apital+ $ach source offinancing has a different cost- apitalstructure affects the cost of capital-

• /) 0he 1ptimal apital Structure is theone that minimi2es the firm’s cost ofcapital and maximi2es firm *alue-

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0uestions hile a2ing the3inancing Decision

• *o should the investment pro4ect !e financed+• Does the ay in hich the investment pro4ects are

financed matter+• *o does financing affect the shareholders( ris2% return

and value+• Does there e'ist an optimum financing mi' in terms of

the ma'imum value to the firm(s shareholders+• Can the optimum financing mi' !e determined in practice

for a company+• 5hat factors in practice should a company consider in

designing its financing policy+

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78T9 : CA89TAL ST;:CT:;<

• 7ptimum capital structure is the capitalstructure at hich the mar2et value pershare is ma'imum and the cost of capitalis minimum.

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8ATT<;>S ? 37; S 73 CA89TALST;:CT:;<

3ollo ing are the forms of capital structure.• Complete equity share capital@

• Different proportions of equity andpreference share capital@• Different proportions of equity and

debenture 3debt $ capital and• Different proportions of equity %

preference and debenture 3debt $ capital.



APPROACHES TO DETERMINE APPROPRIATE CAPITAL

STRUCTURE • EBIT – EPS Approach B This approach is

helpful to analy e the impact of de!t on

earnings per share.• Valuation Approach B This approach

determines the impact of de!t use on theshare holders value and

• Cash lo! Approach " This approachanal#s$s th$ %ir&'s ($)t s$r*ic$ capacit#

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Leverage

Leverage is the employment of anasset?source of finance for hich firm payfi'ed cost?fi'ed return. 9t may of threetypesE

• 1perating !e*erage• Financial !e*erage• ombined !e*erage

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7perating Leverage

• 7perating leverage is caused due to fi'edoperating e'penses in the firm. 9t may !edefined as the firm(s a!ility to use fi'edoperating costs to magnify the effects ofchanges in sales on its earnings !eforeinterest and ta'es. 7perating leverage is

associated ith investment "assetsac#uisition$ activities.

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A firm sells products for ;s. 1 per unit%has varia!le operating cost of ;s. perunit and fi'ed operating cost of ;s. per year. Sho the various levels of <F9Tthat ould results from the sale of "i$ 1units% "ii$ ) units and "iii$ , units.

1,



*o to calculate 7L+

• The degree of operating leverage may !e defined as thechange in the percentage of operating income "<F9T$% forthe change in percentage of sales revenue. The degreeof operating leverage at any level of output is arrived at

!y dividing the percentage change in <F9T ithpercentage change in sales. That is

#egree of 1perating !e*erage 3#1!) 4 Percentagechange in $B&0 5 Percentage change in sales

7r#1!4 ontribution 5 1perating profit 3$B&0)

1-



9mpact of 7L

7perating leverage may !e favora!le or unfavora!le. *ighdegree of operating leverage indicates that high degreeof ris2 . 9t is good hen revenues are rising and !ad

hen they are falling.

7perating ris2 "!usiness ris2$ is the ris2 of the firm not!eing a!le to cover its fi'ed operating costs. The largerthe magnitude% the larger the volume of sales re#uired tocover all fi'ed costs.

• Application of 7perating Leverage• 9t is helpful to 2no ho operating profit "<F9T$ ould change ith a

given change in units produced.• 9t ill helpful in measuring !usiness ris2.

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3inancial Leverage

• 3inancial leverage is the a!ility of the firmto use fi'ed financial charges to magnifythe effects of changes in <F9T on thefirm(s earnings per share.

• 9n other ords% financial leverage may !edefined as the payment of fi'ed rate of

interest for the use of fi'ed interest!earing securities to magnify the rate ofreturn on e#uity shares

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• The financial manager of the *ypotheticalLtd. e'pects that its <F9T in the current

year ould amount to ;s. 1 % . The firmhas per cent !onds aggregating ;s.- % % hile the 1 percent preferenceshares amount to ;s. ) % . 5hat ould

!e the earning per share + Assuming the <F9T !eing "i$ ;s. /% % and"ii$ ;s. 1-% % ho ould the <8S !eaffected. The firm can !e assumed to !e inthe , percent ta' !rac2et. The no. ofoutstanding shares is 1 .

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3inancial leverage in computed !ythe follo ing formula

Degree of financial leverage "D3L$G 8ercentagechange in <8S divided !y 8ercentage change in<F9T

t Dp

I EBIT

EBIT FL

−

−−

=

1

1=



9mpact of 3L

• 3inancial leverage may !e positive or negative.favora!le leverage occurs hen the firm earnsmore on the assets purchased ith the funds%than the fi'ed cost of their use and vice versa.*igher the degree of financial leverage leads tohigh financial ris2.

• The financial ris2 refers to the ris2 of the firm

not !eing a!le to cover its fi'ed financial costs.*ence% financial manager should ta2e intoconsideration the level of <F9T and fi'edcharges hile preparing the firm(s financial plan.

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<F9T <8S analysisSuppose a firm has a capital structure e'clusivelycomprising of ordinary shares amounting to ;s. 1 % % .the firm no ishes to raise additional ;s. 1 la2hs fore'pansion. The firm has four alternative financial plansE

1$9t can raiser the entire amount in the form of e#uitycapital.

)$ 9t can raise percent as e#uity capital and percentas H de!entures.,$ 9t can raise the entire amount as /H de!entures-$ 9t can raise as percent as e#uity capital and H as

H preference capital.

3urther assume that the e'isting <F9T are ;s. 1%) % % theta' rate is , percent% outstanding ordinary shares 1 %and the mar2et price per share is ;s. 1 under all the fouralternatives.5hat financing plan should the firm accept+

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F&6"6 &"! B7$"8 $9$6 P1&60

• 9t is the level of <F9T that a firm must earnto pay its fi'ed financial charges.

3inancial F<8 G 9nterest I Dp "1 t$

)1



9>D933<;<>C< 879>T

• 9t is the <F9T level at hich the <8S issame for t o alternative financial plans. 9tis !eyond this point only% the !enefits offinancial leverage accrues ith respect to<8S.

))



The financial manager of a company hasformulated follo ing financial plans to finance

;s. , la2hs re#uired to implement variouscapital !udgeting pro4ectsE "i$ <ither e#uity capital of ;s. , la2hs

or;s. 1 la2hs 1 H de!enture and ;s.1 La2hs

e#uity.Jou are re#uired to determine the indifferencepoint for each financial plan % assuming , percent corporate ta' rate and the face value ofe#uity shares as ;s. 1 .

),



The financial manager of a company has formulatedfollo ing financial plans to finance ;s. , la2hs re#uired toimplement various capital !udgeting pro4ectsE +ii, Eith$r $-uit# capital o% Rs./0 la1hs or 2/3 pr$%. shar$so% Rs.20 la1hs an( Rs.40 la1hs $-uit# . "iii$ <ither e#uity Capital of ;s., la2hs or 1,H pref. capitalof ;s.1 la2hs "su!4ect to dividend ta' of 1 H$% ;s.1 la2hs

1 H de!entures and ;s.1 la2hs e#uity. "iv$ <ither e#uity share capital of ;s.) la2hs and 1 Hde!entures of ;s.1 la2hs or 1,H pref. capital of ;s.1la2hs% 1 H de!entures of ;s.= la2hs and ;s.1) la2hs e#uity.

Jou are re#uired to determine the indifference point for eachfinancial plan % assuming , per cent corporate ta' rate andthe face value of e#uity shares as ;s. 1 .

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Com!ined Leverage

7r

G Contri!ution<F9T 9 Dp?"1 t$

7;G 3L ' 7L

salesChange% EPSinchange%

EBITinChange%EPSinChange%*

salesinchange%EBITinChange%

==CL

• The degree of com!ined leverage may !edefined as the percentage change in <8Sdue to the percentage change in sales.

• Thus the com!ined leverage isE

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9mpact of CL

• The com!ined leverage can or2 in !othdirections. 9t is favora!le if sales increase andunfavora!le hen sales decrease.

• This is !ecause the change in sales results inmore than proportion returns in the form of <8S.3inancial leverage and operating leverage are

something li2e dou!le edged s ord.• They have tremendous acceleration or

deceleration effects on <F9T and <8S. A rightcom!ination of these leverage is !lessing forcorporate gro th% hile an improper com!inationmay prove as a curse.

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)6



)=



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,

NOATR =Net Operating Assets Turnover RatioRONOCA = Return on Net Operating Current Assets

NONOCA = Non-operating Current AssetsRONOCA = Return on Net Operating Current Assets



Assignment for student

• 3ind out the 1 >S< listed Companiesand calculate 3inancial % com!ined and7peration leverage and 9nterpret thesame. The sources of information are

.nseindia.com8ro ess data !ase3irms( e!sites

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http://www.nseindia.com/

http://www.nseindia.com/



De!t e#uity i' and the Kalue ofthe 3irm

• Capital structure theoriesE B >et income ">9$ approach.

B >et operating income ">79$ approach. B hypothesis ith and ithout

corporate ta'.

B Traditional approach

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ASS: 8T97> 73 CA89TAL ST;:CT:;<T*<7;9<S

1$ There are only t o sources of funds i.e.E de!t and e#uity.)$ The total assets of the company are given and do nochange.

,$ The total financing remains constant. The firm canchange the degree of leverage either !y selling the shares

and retiring de!t or !y issuing de!t and redeeming e#uity.-$ 7perating profits "<F9T$ are not e'pected to gro .$ All the investors are assumed to have the same

e'pectation a!out the future profits./$ Fusiness ris2 is constant over time and assumed to !e

independent of its capital structure and financial ris2.6$ Corporate ta' does not e'it.=$ The company has infinite life.

$Dividend payout ratio G 1 H.

,,



>et 9ncome ">9$ Approach

• According to >9 approach !oth the cost of de!tand the cost of e#uity are independent of thecapital structure@ they remain constant

regardless of ho much de!t the firm uses. As aresult% the overall cost of capital declines and thefirm value increases ith de!t.

• This approach has no !asis in reality@ theoptimum capital structure ould !e 1 per centde!t financing under >9 approach

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Capital-structure Unit III 6 3 2014 Ppt