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CAPITAL STRUCTURE

INTRODUCTION In order to run and manage-a company, funds are needed. Right from the promotional stage up to end, finances play an important role in a company's life. If funds are inadequate, the business suffers and if the funds y, are not properly managed, the entire organisation suffers. It is, therefore, necessary that correct estimate of the current and future need of capital be made to have an optimum capital structure which shall help the organisation to run its work smoothly and without any stress. Estimation of capital requirements is necessary, but the formation of a capital structure is important. According to Gerestenbeg,"Capital structure of a company refers to the composition-or make-up of its capitalisation and it includes all long-term capital resources viz: long-term capital, shares' and bonds." 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 funds. CAPITALISATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE The terms, capitalisation, capital structure and financial structure, do not mean the same. While capitalisation is a quantitative aspect of the financial planning of an enterprise, capital structure is concerned with the qualitative aspect. Capitalisation refers to the total amount of securities issued by a company while capital structure refers to the kinds of securities and the proportionate amounts that make up capitalisation. For! raising long-term finances, a company can issue three types of securities viz. Equity shares, Preference Shares and Debenture. A decision about the proportion among these type of securities refers to the capital structure i c of an enterprise. , " Some authors on financial management define capital structure in a broad sense so as to include even the at proportion of short-term debt. In fact, they refer to capital structure as financial structure. Financial structure means the entire liabilities side of the balance sheet. In the words of Numbers and Grunewald, 'Financial structure refers to all the financial resources marshalled by the firm, short as well as long-term, and all forms of debt as well as equity. Thus financial structure, generally, is composed of a specified percentage of short-term debt, long-term shareholders funds. FORMS/PATTERNS OF CAPITSTRUCTURE The capital structure of a new company may consist of any of the following forms : 1. Equity Shares only X 2. Equity and Preferences Shares 3. Equity Shares and Debentures 4. Equity Shares, Preferences Shares and Debentures. IMPORTANCE OF CAPITAL STRUCTURE The term 'Capital structure' refers to the relationship between the various long-term forms of financing such as debenture, preference share capital and equity share capital. Financing the firm's assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing the firms assets. The use of long-term fixed interest bearing debt and preference share capital along with equity shares is called financial leverage or trading on equity. The long-term fixed interest bearing debt is employed by a firm to earn more from the use of these sources than their cost so as to increase the return on owner's equity. It is true that capital structure cannot affect the total earnings of a firm but it can affect the share of earnings available for equity shareholders. Say, for example, a company has an Equity Capital of 1000 shares of Rs. 100 each fully paid and earns an average profits of Rs.30,000. Now the company wants to make an expansion and needs another Rs. 1, 00,000. The options with the company are-either to issue new shares or raise loans @ 10% p.a. assuming that the company would earn the same rate of profits. It is advisable to raise loans as by doing so earnings per share will magnify. The company shall pay only Rs. 10,000 as interest and profit expected shall be Rs.60,000 (before payment of interest). After the payment of interest the profits left for equity shareholders shall be Rs. 50,000 (ignoring tax). It is 50% return on the equity capital against 30% return otherwise. However, leverage can operate adversely also if the rate the interest on long-terms loans is more that the expected rate of earnings of the firm. TRADING ON EQUITY AND CAPITAL GEARING The long term sources are debt and preference share capital along with owners capital in the entire capital structure is known as Trading on Equity or financial leverage. Trading on Equity the management can increase income for the Equity Shareholders by using less amount of Equity Share Capital.

Definition of Trading on Equity. The definitions are as: 1. Gerstenberg "When a person or corporation uses borrowed capital as well as owned. Capital in the regular conduct of business he or it is said to be a trading on equity. 2. Guthmann and Dougall The use of borrowed funds, at a fixed cost of financial a firm is known as Trading on Equity. Conclusion. The process of Trading on Equity will increase earnings per Equity share. It is done by using low dividend and low rate interest. The test of Trading on Equity will be when profit rate on borrowed capitals more than the rate of interest payable on borrowed capital. OBJECTIVES OF TRADING ON EQUITY The main objectives if Trading on Equity are as:1. Higher Rate of Dividend. The main object of Trading on Equity is to increase the amount of dividend on equity share capital. 2. Loan facility. The trading on capital is useful for raising more financial resources. 3. Control on Management. The main privilege of Trading on Equity is that the management of the company vests in few hands. 4. Goodwill. The companies which work on 'Trading on Equity' concept there goodwill increase in the market as their rate of dividend is high and value per share is high, thus, the goodwill of the company goes up. KINDS OF TRADING OF EQUITY The Trading on Equity can be grouped as: 1. Trading on Thin Equity. The lesser amount of equity share capital than borrowed capital (Preference and Debentures) such state is known as thin Equity Trading. 2. Trading on thick Equity. Sometimes total long term borrowing are less than equity such situation is known as Trading on Thick Equity. 3. Trading on Equal Equity. When borrowed capita! And equity capital are equal this is known as Trading on equal Equity. IMPORTANCE OF TRADING OF EQUITY The trading on Equity is useful to the management in deciding the composition of capital keeping their respective cost of acquiring capital. The following are the points in favour of importance of Trading upon Equity: 1. Lesser owned capital. Trading on equity is that state of affair that owner's capital is less than borrowed capital. 2. More Dividends to shareholders. The Policy of Trading on Equity is always suitable to investors as their dividend per share goes up. 3. More market value. As a direct result of more dividend, the market value of the shares go up thus the shareholders can sell their holding at a high price. 4. More Goodwill of the company. A company working with Trading on Equity concept has very good market value and such company can secure loans on lesser interest rate. 5. Lesser Financial botheration. Corporation which are Trading on Equity will not feel shortage of funds nor will any difficulty of Expansion and modernisation up set the Financial Discipline. 6. Guard against risks. The management should watchful toward the downfall in profits as one hand fall in profit and on the other hand interest to be paid out on borrowed capital will be set the soundness of the company thus, the management always keep an effective guard. LIMITATIONS OF TRADING ON EQUITY The basis of Trading on Equity is the borrowed capital. Every company has effort a certain level of interest borrowing over a certain limit may consume' lot of revenues and lowering the dividend to shareholders. This situation is not at all desirables. Thus, trading on equity suffers from the following limitations: 1. Certain and Regular Income. Trading on Equity is not suitable to such corporation where income is irregular and uncertain. Trading on Equity is not desirable under conditions of Deflation. 2. High fate Interest. The company seeking long term loan and the rate of borrowing are very high thus the interest burden goes on piling up.

3. Interference of Lenders. The corporate who work on Trading on Equity by taking loan, the lenders interference and their influence dominate the working of the corporate. Every new loan will need their consent and thus, their new terms and conditions will harm the interest of shareholders. 4. Over-capitalisation. There is always a limit in borrowed capital beyond this limit loan will result in overcapitalised and the fixed rate of interest becomes a permanent liability. Thus, further borrowing will not be easy, low dividend and the market value of the shares will come down. 5. Legal Restrictions. Sometimes the laws of that country specify certain limits on borrowed capital thus; no more borrowing can be exercised. In many cases borrowed capital is profitable but due to restrictions imposed by Memoranda or Articles of Associations the company cannot borrow beyond a specific limit. 6. Management Attitude. The rate of return on capital employed is-comparatively very high, the low rate of interest on borrowed capital is easily available yet, much management do not prefer to borrow capital for their organisation. The Stress for owned capital rather than borrowed capital. CAPITAL GEARING The different elements of capital structure and their relation is known as Capital Gearing. Here balance ratio between different sources of capital is established In other, Capital Gearing is the relationship between Equity Capital and fixed interest bearing securities (Preference Share Capital + Debentures and Bonds). DEFINITION OF CAPITAL GEARING The main definitions are: 1. J. Betty. "The relation of ordinary share (Equity Shares) to preference share capital and loan capital is described as the Capital Gearing." 2. Brown and Howard. "The term Capital Gearing is used to describe the ratio between the ordinal Share Capital and fixed interest bearing securities of a company." Techniques of Capital Gearing. The Capital Gearings is compared to motor gearing wherein low Gear is used to start the motor and later on the speed it up high Gear is used. Same is true in business in the initial stages low Gear be used thus fixed interest cost capital be used lesser. When business grows up, income shows regularity and certainly than High Gear Capital can be exercised thus, in total capital the ratio of High Cost Capital big increased. There are three techniques of Capital Gearing. A. Variable Cost Capital B. Fixed Cost Capital C. zero Cost Capital. a. Variable Cost Capital. The capital where return is not certain, it may be more or less, the Equity share capital falls under this category. b. Fixed Cost Capital. This is such capital where dividend and interest are always be fixed rats in this category preference share capital and Debentures are covered. c. Zero Cost Capital. All such resources of a business which are available to the corporate and no interest are. Paid by the corporation is known as Zero Cost Capital. In this category reserves and surpluses and outstanding expenses are covered. Importance of Capital Gearing. The following are the main points, which can be placed to highlight the significance of Capital Gearing: 1. Capital Structure. Capital Gearing is useful for capital structure, wherein the ratios of different capital are designed. 2. Dividend Policy. Capital Gearing decides the most reasonable capital mix thus, Dividend to shareholders without any cost. 3. Reserves and Surpluses. The Reserves and surpluses can be used for expansion and modernisation without any cost. 4. Helpful in Trade Cycle. There are two situations of trade cycles: a. Boom. In this situation the company can use borrowed capital as the demand for the product is increased. The company can go for high capital gearing ratio, which means more profits to company. Depression. In this situation low Gear Capital is recommended which checks more borrowed capital thus the interest of shareholder is saved. Type of Capital Gearing. Capital gearing is of two types:-

1. High Capital Gearing 2. Low Capital Gearing 1. High Capital Gearing. Sometimes the total capitalisation fixed interest and fixed dividend bearing securities are more than ordinary shares, such a situation is known high gearing of capital. For example the total capitalisation of a company is Rs. 10,00,000 which has ordinary share capital of Rs. 3,00,000 debentures of Rs. 4,00,000 and preference shares of Rs. 3,00,000, In such a case, the total of debentures and preference shares (Rs. 7,00,000) is greater to the ordinary shares (Rs. 3,00,000). The capital structure of the company will be said to be highly geared. 2. Low Capital Gearing. When total capitalised amount of fixed interest and fixed dividend bearing securities is less than ordinary share capital, it will be a situation of low gearing of capital. In the above example if ordinary share capital is Rs. 8, 00,00 and debentures Rs. 1,00,000 and preference shares are Rs. 1,00,000, it will be low gearing of capital. Gear Ratio: Gearing Ratio can be calculated by use of following formula. Gear Ratio = Equity share capital + Reserves & surplus Fixed cost t bearing capital Company whose shares sell below the face value may find it difficult to improve its goodwill in the market, Gear Ratio: Gearing Ratio can be calculated by use of following formula. Equity share capital + Reserves & Surplus Gear Ratio= Fixed cost gearing capital COST OF CAPITAL The cost of capital of a firm is the minimum rate of return expected by its ,investors. It is the weighted average cost of various sources of finance used by a firm. The capital used by a firm may be in the form of debt, preference capital, retained earnings and equity shares. The concept of cost of capital is very important in the financial management. A decision to invest in a particular project _depends upon the cost of capital of the firm or the cutoff rate which is the minimum rate of return expected by the investors. In case a firm is not able to achieve-even the cut off rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected by it investors which will maintain the market value of shares at its present level. Hence, to achieve the objective of wealth maximisation, a firm must earn a rate of return more than its cost of capital. Further, optimal capital structure maximizes the value of a firm and hence the wealth of its owners and minimizes the firm's cost of capital. The cost of capital of a firm or the minimum rate of return expected by its investors has a direct relation with the risk involved, in the firm. Generally, higher the risk involved in a firm, higher is the cost of capital. Cost of capital for a firm may be defined as the cost of obtaining funds, i.e., the average rate of return that the investors in a firm would expect for supplying funds to the firm. In the words of Hunt, William and Donaldson, "Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due". James C. Van Home defines cost of capital as, "a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock." According to Solomon Ezra, "Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures. Hampton, John J. defines cost of capital as, "the rate of return the firm requires from investment in order tot increase the value of the firm in the market placed "Thus, we can say that cost of capital is that minimum rate of return which a firm, must and, is expected to earn on its investments so as to maintain the market value of its shares. From the definitions given above we can conclude three basic aspects of the concept of cost of capital: (i) Cost of capital is not a cost as such. In fact, it is the rate of return that a firm requires to earn from its projects. ( ii) It is the minimum rate of return. Cost of capital of a firm is that minimum rate of return which will at least maintain the market value of the shares. (iii) It comprises of three components. As there is always some business and financial risk in investing funds in a firm, cost of capital comprises of three components : (a) the expected normal rate of return at zero risk level, say the rate of interest allowed by bank.(b) the premium for business risk ; and ( c) the premium for financial risk on account of pattern of capital structure. Symbolically cost of capital may be represented as :

K=r0 +b +f where, K= Cost of capital r0 =Normal rate of return at zero risk level b= Premium for business risk. f= Premium for financial risk.

SIGNIFICANCE OF THE COST OF CAPITAL The concept of cost of capital is very important in the financial management. It plays a crucial role in both capitals budgeting as well as decisions relating to planning of capital structure. Cost of capital concept can al be used as a basis for evaluating the performance of a firm and it further helps management in taking so man;, other financial decisions,. 1. As an Acceptance Criterion in Capital budgeting. In the words of James T.S. Posterfield 'the concept of cost of capital has assumed growing importance largely because of the need to devise a rational mechanism for making the investment decisions of the firm', Capital budgeting decisions can be made by considering the cost of capital. According to the present value method of capital budgeting, if the present value of expected returns from investment is greater than or equal to the cost of investment, the project may be accepted ; otherwise ; the project may be rejected. The present value of expected returns is calculated by discounting the expected cash inflows at cut-off rate (which is the cost of capital). Hence, the concept or cut off capital is very useful in capital budgeting decision, 2. As a Determinant of Capital Mix in Capital Structure Decisions. Financing the firm's assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing a firm's assets. While designing an optimal capital structure, the management has to keep in mind the objective of maximising the value of the firm and minimising the cost of capital. Measurement: . c cost of capital from various sources is Very essential in planning the capital structure of any firm. 3. As A Basis for Evaluating the Financial Performance. In the words of S.K. Bhattacharya the concept of cost of capital can De used to "evaluate the financial performance of top management'. The actual profitability of the project is compared to the projected overall cost of capital and the actual cost of capital of funds raised to finance the project If the actual profitability of the project is more than the projected and the actual cost : capital, the performance may be said to be satisfactory. 4. As a Basis for taking other Financial Decisions. The cost of capital is also used in making other financial decisions such as dividend policy, capitalisation of profits, making the rights issue and workup capital. CLASSIFICATION OF COST 1. Historical Cost and Future Cost. Historical costs are book costs which are related to the past. Future costs are estimated costs for the future. In financial decisions future costs are more relevant than the historical costs. However, historical costs act as guide for the estimation of future costs. 2. Specific Cost and Composite Cost. Specific cost refers to the cost of a specific source of capital while composite cost is combined cost of various sources of capital. It is the weighted average cost of capital. In case more than one form of capital is used in the business, it is the composite cost which should be considered for decision-making and not the specific cost. But where only one type of capital is employed the specific cost of that type of capital may be considered. In capital structure decisions, it is the weighted average cost of capital which should be given consideration. 3. Explicit Cost and Implicit Cost. An explicit cost is the discount rate which equates the present value of cash inflows with the present value of cash outflows. In other words, it is the internal rate of return. The explicit cost of a specific source of finance may be determined with the help of the following formula: O1 O2 + (1+K) (1+K)
2

On + (1+K)
n

n =

Ot (1+K)
t

l0 =

t=1

where,

I0, is the net cash inflow at zero point of time,

O is the outflow of cash in periods 1, 2 and n. k is the explicit cost of capital. Implicit cost also known as the opportunity cost is the cost of the opportunity foregone in order to take up a particular project. For example, the implicit cost of retained earnings is the rate of return available to shareholders by investing the funds elsewhere. 5. Average Cost and Marginal Cost. An average cost refers to the combined cost of various sources of capital such as debentures, preference shares and equity shares. It is the weighted average cost of the costs of various sources of finance. Marginal cost of capital refers to the average cost of capital which has to be incurred to obtain additional funds required by a firm. In investment decisions, it is the marginal cost which should be taken into consideration. DETERMINATION OF COST OF CAPITAL It has already been stated that the cost of capital plays a crucial role in the decisions relating to financial management. However, the determination of the cost of capital of a firm is not an easy task because of conceptual problems as well as uncertainties of proposed investments and the pattern of financing. The major problems concerning the determination of cost of capital are discussed as below. Problems in Determination of Cost of Capital 1. Conceptual controversies regarding the relationship between the cost of capital and the capital structure. Different theories have been propounded by different authors explaining the relationship between capital structure, cost of capital and the value of the firm. This has resulted into various conceptual difficulties.. According to the Net Income Approach and the traditional theories both the cost of capital as well the value of the firm have a direct relationship with the method and level of financing. In their opinion, a firm can minimise the weighted average cost of capital and increase the value of the firm by using debt financing. On the other hand, Net Operating Income and Modigliani and Miller Approach prove that the cost of capital is not affected by changes in the capital structure or say that debt equity mix is irrelevant in determination of cost of capital and the value of a firm. However, the M and M approach is based upon certain unrealistic assumptions such as, there is a perfect market or the expected earnings of all the firms have identical risk characteristic, etc. 2. Historic cost and future cost. Another problem in the determination of cost of capital arises on account of the difference of opinion as regards the concept of cost itself. It is argued that historic costs are book costs which are related to the past and are irrelevant in the decision-making process. In their opinion, future estimated costs are more relevant for decision-making. In the same manner, arguments are given in favour of specific cost and composite cost as well as explicit cost and implicit cost and the marginal cost. 3. Problems in computation of cost of equity. The computation of cost of equity capital depends upon the expected rate of return by its investors. But the quantification of the expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm. 4. Problems in computation of cost of retained earnings. It is sometimes argued that retained earnings do not involve any cost. But in reality, it is the opportunity cost of dividends foregone by its shareholders. Since different shareholders may have different opportunities for investing their dividends, it becomes very difficult to compute the cost of retained earnings. 5. Problems in assigning weights. For determining the weighted average cost of capital, weights have to be assigned to the specific cost of individual sources of finance. The choice of using the book value of the source or the market value of the source poses another problem in the determination of cost of capital. COST OF SPECIFIC SOURCE OF FINANCE Computation of each specific source of finance, viz, debt, preference share capital, equity share capital and retained earnings is discussed as below: 1. COST OF DEBT. The cost of debt is the rate of interest payable on debt. For example, a company issues Rs. 1,00,000 10% debentures at par; the before-tax cost of this debt issue will also be 10%. By way of a formula, before-tax-cost of debt may be calculated as :.. K db =I/P

Where

K = before tax cost of debt I = Interest P = Principal In case the debt is raised at premium or discount, we should consider P as the amount of net proceeds received from the issue and not the face value of securities. The formula may be changed to (ii) K db = I/NP (where, NP= Net Proceeds) Further, when debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductable expense in computation of tax. Hence, the effective cost of debt is reduced. The After-tax cost of debt may be calculated with the help of following formula: (iii) K db = K db (l-t) = I/NP (1-t) where, K, = After-tax cost of debt t = Rate of tax. Cost of Redeemable Debt Usually, the debt is issued to be redeemed after a certain period during the life time of a firm. Such a debt issue is known as Redeemable debt. The cost of redeemable debt capital may be computed as: (iv) Before-tax cost of debt, (iv) I+1/n (P-NP) , K db = 1/2 (P+NP) where, I = Interest N= Number of years in which debt is to be redeemed P = Proceeds at par NP = Net Proceeds

(v)

After-tax cost of debt, K = K (1-f) I+1/n (P-NP) where, K db = 1/2 (P+NP)

2. COST OF PREFERENCE CAPITAL A fixed rate of divided is payable on preference shares. Though dividend is payable at the discretion of the Board of directors and there is no legal binding to pay dividend, yet it does not mean that preference capital is cost free. The cost of preference capital is a function of dividend expected by its investors, i.e., its stated dividend. In case dividends are not paid to preference shareholders, it will affect the fund raising capacity of the firm. Hence, dividends are usually paid regularly on preference shares except when there are no profits to pay dividends. The cost of preference capital which is perpetual can be calculated as : Kp=D/ P Kp = Cost of Preference Capital D = Annual Preference Dividend P = Preference Share Capital (Proceeds.) Further, if preference shares are issued at Premium or Discount or when costs of floatation are incurred to issue preference shares, the nominal or par value of preference share capital has to be adjusted to find out the net proceeds from the issue of preference shares. In such a case, the cost of preference capital can be computed with the following formula: K = H p NP It may be noted that as dividends are not allowed to be deducted in computation of tax, no adjustment is required for taxes. Sometimes Redeemable Preference Shares are issued which can be redeemed or cancelled on maturity date. The cost of redeemable preference share capital can be calculated as : D+MV-NP/n Where,

Kpr= where, (MV+NP) K = Cost of Redeemable Preference Shares D = Annual Preference Dividend MV = Maturity Value of Preference Shares NP = Net Proceeds of Preference Shares.

COST OF EQUITY SHARE CAPITAL. The cost of equity is the 'maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock.' The cost of equity capital is a function of the expected return by its investors. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at affixed rate every year. Moreover, payment of dividend is not a legal binding. It may or may not be paid. But it does not mean that equity share capital is a cost free capital. Shareholders invest money in equity shares on the expectation of getting dividend and the company must earn this minimum rate so that the market price of the shares remains unchanged. Whenever a company wants to raise additional funds by the issue of new equity shares, the expectations of the shareholders have to evaluated. The cost of equity share capital can be computed in the following ways Dividend Yield Method or Dividend/Price Ratio Method. According to this method, the cost of equity capital is the 'discount rate that equates the present value of expected future dividends per share with the net proceeds (or current market price) of a share'. Symbolically; Ke=D/NP or D/MP where,

Kc = Cost of Equity Capital D = Expected dividend per share NP = Net proceeds per share and MP = Market Price per share. The basic assumptions underlying this method are that the investors give prime importance to dividends and risk in the firm remains unchanged The dividend price ratio method does not seem to consider the growth in dividend, (i) it does not consider future earnings or retained earnings, and (ii) it does not take into account the capital gains. This method of computing cost of equity capital is suitable only when the company has stable earnings and stable dividend policy over a period of time. COST OF RETAINED EARNINGS It is sometimes argued that retained earnings do not involve any cost because a firm is not required to pay dividends on retained earnings. However, the shareholders expect a return on retained profits. Retained earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the dividends out of the available profits. ~ The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualifies it is thus the opportunity cost of dividends foregone by the shareholders. Cost of retained earnings can be computed with the help of following formula; Kr=D/NP+G where, K = Cost of retained earnings D. = Expected dividend NP = Net proceeds of share issue G=Rate of growth. Further, it is important to note that shareholders, usually, cannot obtain the entire amount of retained profits by way of dividends even if there is 100 per cent pay out ratio. It is so because the shareholders are required to pay tax on their dividend income. So, some adjustment has to be made for tax. However,. tax adjustment in determining the cost of retained earnings is a difficult problem because all shareholders do not fall under the same tax bracket. Moreover, if the share holders wish to invest their after-tax dividend income in alternative securities, they may have to incur some costs of purchasing the securities, such as brokerage. Hence, the effective rate of return realised by the shareholders from the new investment will be somewhat lesser than their present return

from the firm. To make adjustment in the cost of retained earnings for tax and costs of purchasing new securities, the following formula may be adopted : WEIGHTED AVERAGE COST OF CAPITAL Once the specific cost of capital of each of the long term sources i.e., the debt, the preference share capital, the equity share capital and the retained earnings have been ascertained, then the next step is to calculate the overall cost of capita! Of the firm. This overall cost of capital of the firm is relevant as this rate is used as the discount rate or the cut-off rate in evaluating the capital budgeting proposals. The overall cost of capital may be defined as the rate of return that must be earned the firm in order to satisfy the requirements of the different investors. The overall cost of capital is thus, the minimum required rate of return on the assets of the firm. This overall cost of capital should take care of the relative proportion different sources in the capital structure of the firm. Therefore, this overall cost of capital should be calculated as the weighted average rather than simple average of different specific cost of capital. The weighted average cost of capital (WACC defined as the weighted average of the cost of different sources and may be described as follows : WACC Ke.w 1 + k,.w2 +k .w3 Where, WACC Weighted Average Cost of Capital Ke Cost of equity capital Kd after tax cost of debt Kp Cost of preference shares W1 Proportion of equity capital in capital structure W2 Proportion of debt in capital structure W3 Proportion of preference capital in capital structure. As most of the firms use more than one source of capital fund in financing the capital budgeting proposals and because over time, the mix of these sources may change, it is necessary to examine the cost of the firm's capital structure as a whole. The firm must have a cost of capital that is weighted to reflect the differences in various sources used. It encompasses the cost of compensating the debt investors, preference shareholders and the equity shareholders. So, in order to calculate the WACC, there must be a system of assigning weights to different specific cost of capital. The following considerations are worth noting while assigning weights to specific cost of capital to find out the WACC. Historical, Marginal and Target Weights: As already noted, the WACC is found by weighing the specific cost of capital for each type of financing by its proportion in the overall capital structure. The weights which may be assigned and used to find out the WACC may be as follows: A. Historical or Existing Weights: Historical or existing weights are the weights based on the actual or existing proportions of different sources in the overall capital structure. Such weighing system is based on the actual proportions at the time when the WACC is being calculated. In other words, the weighing system is the proportions in which the funds have already been raised by the firm. The use of historical weights is based on two important assumptions namely (i) that the firm would raise the additional resources required for financing the investment proposals, in the same proportions in which they are appearing at present in the capital structure, and (ii) that the present capital structure is optimal and therefore the firm wants to continue with the same pattern in future also. However, there may be some problems in applying the historical weights. The firm may not be able to raise additional finance in the same proportion as existing one because of prevailing economic and capital market conditions, legal constraints or other factors. Further, the assumption of existing capital structure being the optimal one may not always hold good. B. Marginal Weights: The other system of assigning weights is the marginal weights system. The marginal weights refer to the proportions in which the firm wants or intends to raise funds from different sources. In other words, the proportions in which additional funds required to finance the investment proposals will be raised are known as marginal weights. So, in case of marginal weights, the firm in fact, calculates the actual WACC of the incremental funds. Theoretically, the system of marginal weights seems to be good enough as the return from investment will be compared with the actual cost of funds. Moreover, if a

particular source which has been used in the past but is not being used now to raise additional funds, or cannot be used now, for one or the other reason, then why should it be allowed to enter the decision process even through the weighing system? However, there are some shortcomings of the marginal weights system. In particular, the capital budgeting decision process requires the long term perspective whereas the marginal weights ignore this. In the short run, the firm may be tempted to raise funds only from cheaper sources and thereby accepting more and more proposals. However, later on when other sources will have to be resorted to, some projects which should have been accepted otherwise, will be rejected because of higher cost of capital. C. Target Weights: The target weights refer to the proportion in which the firm plans to raise the funds from various sources in the long run. In other words, the target weights system reflects the desired long term financial plans or capital structure of a firm. In the target weights system, the firm in the first instance decides about the shape of the optimal capital structure and proportion of different sources in this optimal capital structure. This, then, will be achieved by the firm in the long run. At a particular point of time, the actual capital structure may not be the optimal capital structure, but in the long run, the firm intends to shape it as an optimal capital structure. If a firm already has an optimal capital structure, then its historical weights will be equal to the target weights. Unless a firm's existing capital structure significantly differs from the optimal capital structure, the WACC using historical weights is not expected to be different from the WACC using target weights. Theoretically speaking, the use of the target weights is the best option as this system incorporates the long term perspective of the firm. In the following discussion, therefore, the target weights system will be used to find out the WACC. Book Value versus Market Value Weights: The weights to be used for calculation of WACC can either be based on the book value or the market value of the funds raised from different sources. A. Book Value Weights: The weights are said to be book value weights if the proportions of different sources are ascertained on the basis of the face values i.e., the accounting values. The book value weights can be easily calculated by taking the relevant information from the capital structure as given in the balance sheet of the firm. The book value weights are considered as a sound weighing system as it is operational in nature and a firm may design its capita! Structure in terms of as it appears in the balance sheet. However, the book value weights system does not truly reflect the economic values. In fact, the weighing system should be market determined. The book value weights system is not consistent with the definition of the overall cost of capital, which is defined as the minimum rate of return needed to maintain the firm's market value. The book value weights ignore the market values. B. Market Value Weights: The weights may also be calculated on the basis of the market value of different sources i.e., the proportion of each source at its market value. In order to calculate the market value weights, the firm has to find out the current market price of the securities in each category. However, a problem may arise if there is no market value available for a particular type of security. The advantages of using the market value weights may be 1. The market value weights are consistent with the concept of maintaining market value in the definition of the overall cost of capital. 2. The market value weights provide current estimate of the investor's required rate of return. 3. The market value weights yield good estimate of the cost of capital that would be incurred should the firm require additional funds from the market. 4. However, the market values weights suffer from some limitations as follows: 5. Not only that the market values of all types of securities issued have to be obtained but also that the market value of equity share is to be segregated into capital and retained earnings. 6. The market values are subject to change from time to time and so the concept of optimal capital structure in terms of market values does not remain relevant any longer. 7. External factors which affect the market value, will affect the cost of capital also and therefore, the investment decision process will be influenced by the external factors. The weights to be assigned to different sources of funds are clearly going to be different if the financial analyst choose to apply current market value weights as against the book values as stated in the balance sheet. He must be guided by the purpose of the analysis in deciding which value is relevant. If he is deriving a criterion against

which to judge the expected return from future investment, he should use the current market values of different sources. The investors, certainly, do not invest in the book values of the equity shares, which may differ significantly from the market values. The book values are static and not responsive to changing performance. The choice of market values also complements the use of incremental funding in that both are expressed in the market terms. It may be noted that the market value of equity shares automatically includes thesss retained earnings as reported in the balance sheet. With respect to the choice between the book value and market value weights, the following points are worth noting: a. It is argued that the book value is more reliable than market value because it is not as volatile. Although it is true that book value does not change as often as market value, this is more a reflection of the weakness than of strength, since the true value of the firm changes over time as both the firm specific and the market related information is revealed. b. The WACC based on market value will generally be greater than the WACC based on book values. The reason being that the equity capital having higher specific cost of capital usually has market value above the book value. However, this is not the rule. c. The choice between the book values and the market values is relevant only for historical and target weights. In case of marginal weights, however, the question of choice does not arise at all and the weighing system will be market value based only. THEORIES OF CAPITAL STRUCTURE Different kinds of theories have been propounded by different authors to explain the relationship between capital structure cost of capital and value of the firm. The main contributors to the theories are Durand, Ezra, Solomon, Modigliani arid Miller. The important theories are discussed below: 1. Net Income Approach. 2. Net Operating Income Approach. 3. The Traditional Approach. 4. Modigliani and Miller Approach. 1. Net Income Approach. According to this approach, a firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. The theory propounds that a company can increase its value and reduces the overall cost of capital by increasing the proportion of debt in its capital structure. This approach is based upon the following assumptions: 1. The cost of debt is less than the cost of equity. 2. There are no taxes. 3. The risk perception of investors is not changed by the use of debt. The line of argument in favour of net income approach is that as the proportion of debt financing in capital structure increase, the proportion of an cheaper source of funds increases. This results in the decrease in overall (weighted average) cost of capital leading to increase in the value of the firm. The reasons for assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than dividend rates due to element of risk and the benefit of tax as the interest is a deductible expense. 2. Net operating Income Approach. This theory as suggested by Durand is another extreme of the effect of leverage on the value of the firm. It is diametrically opposite to the net income approach. According to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the debt-equity mix is 50:50 or 20:80 or 0:100. Thus, there is nothing as an optimalcapital structure and every capital structure is the optimum capital structure. This theory presumes that: 1. The market capitalizes the value of the firm as a whole; 2. The business risk remains constant at every level of debt equity mix. The reasons propounded for such assumptions are that the increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of debt remains constant with the increasing proportion of debt, as the financial risk of the lenders is not affected. Thus, the advantage of using the cheaper source of funds, i.e., debt is exactly offset by the increased cost of equity. Net income approach has been explained in illustration

3. The Traditional Approach. The traditional approach, also known as Intermediate approach, is a compromise between the two extremes of net income approach and net operating income approach. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Thus, optimum capital structure can be reached by a proper debtequity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt. Thus, overall cost of capital, according to this theory, decreases upto a certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases or rises beyond a certain point. Even the cost of debt may increase at this state due to increased financial risk. The theory has been explained in Illustration. 4. Modigliani and Miller Approach. M & M hypothesis is identical with the Net Operating Income approach if taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income Approach. a) In the absence of taxes. The theory proves that the cost of capital is not affected by changes in the capital structure or says that the debt-equity mix is irrelevant in the determination of the total value of as firm. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increase. This increase in cost of equity offsets the advantage of the low cost of debt. Thus, although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The theory emphasis the fact that a firm's operating income is a determinant of its total value. The theory further propounds that beyond a certain limit a debt, the cost of debt increases (due to increased financial risk) but the cost of equity falls thereby again balancing the two costs. The M & M approach is based upon the following assumptions: 1. There are no corporate taxes. 2. There is a perfect market. 3. Investors act rationally. 4. The expected earnings of all the firms have identical risk characteristics. 5. The cut-off point of investment in a firm is capitalization rate. 6. Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates. 7. All earnings are distributed to the shareholders. b) When the corporate taxes are assumed to exist. Modigliani and Miller, in their article of 1963 have recognised that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum capital structure can be achieved by maximising the debt mix in the equity of a firm. According to the M & M approach, the value of a firm unlevered can be calculated as. Value of unlevered firm (Vu) Earnings Before interest &tax = Overall cost of capital

EBIT Ko

and, the value of a levered firms is : VL=Vu + tD Where Vu is value of unlevered firm and, t D is the discounted present value of the tax savings resulting from the tax deductibility of the interest charges, t is the rate of tax and D the quantum of debt used in the mix. Essential Features of A Sound Capital Mix A sound or an appropriate capital structure should have the following essential features:

1. Maximum possible use of leverage. 2. The capital structure should be flexible. 3. To avoid undue financial/business risk with the increase of debt. 4. The use of debt should be within the capacity of a firm. The firm should be in a position to meet its obligations in paying the loan and interest charges as and when due. 5. It should involve minimum possible risk of loss of control. 6. It must avoid undue under restrictions in agreement of debt. FACTOR DETERMINING CAPITAL STRUCTURE Every time the funds are needed, the financial manager has to study the pros and every time the various sources of finance so as to select the most advantageous capital structure. The factors influencing the capital structure are discussed as follows: 1. Financial Leverage or Trading on Equity. The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity. Effects of leverage on the shareholders return or earnings per share have already been discussed in this chapter. 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 loans is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm. 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 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. 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. While formulating a capital structure, an effort must be made to minimise the overall cost of capital. 4. Cash Flow Ability to Service Debt. A firm which shall be able to generate larger and stable cash inflows can employ more debt in its capital structure as compared to the one which has unstable and lesser ability to generate cash inflows. Debt financing implies burden of fixed charge due to the fixed payment of interest and the principal. Whenever a firm wants to raise additional funds, it should estimate, project its future cash inflows to ensure the coverage of fixed charges, 5. Nature and Size of a Firm. Nature and size of a firm also influence its capital structure. A public utility concern has different capital structure as compared to other manufacturing concern. Public utility concerns may employ more of debt because of stability and regularity of their earnings. On the other hand, a concern which cannot provide stable earnings due to the nature of its business will have to reply mainly on equity capital; similarly, small companies have to demand mainly upon owned capital as it is very difficult for them to raise long-term loans on reasonable terms and also can issue equity and preference shares at case to the public. 6. Control. Whenever additional funds are required funds by a firm, the management of the firm wants to raise the funds without any loss of control over the firm. In case the funds are raised through the issue of equity shares, the control of the existing shareholders is diluted. Hence, they might raise the additional funds by way of fixed interest bearing debt and preference shareholders and debenture holders do not have the voting right. Hence, from the point of view of control, debt financing is recommended. 7. Flexibility. Capital structure of a firm should be flexible, i.e., it should be such as to be capable of being adjusted according to the needs of the changing conditions. It should be possible to raise additional fund, whenever the need be, without much of difficulty and delay. 8. Requirements of Investors. The requirements or investor is another factor than influence the capital structure of a firm. It is necessary to meet the requirements of both institutional as well as private investors when debt financing is used. 9. Capital Market Conditions. Capital market conditions do not remain the same forever. Sometimes there may be depression while at other times there may be boom in the market. The choice of the securities is also influenced by

the market conditions. If the share market is depressed and there are pessimistic business conditions, the company should not issue equity shares, as investors would prefer safety. But in case there is boom period, it would be advisable to issue equity shares. 10. Assets Structure. The liquidity and the composition of assets should also be kept In mind while selecting the capital structure. If fixed assets constitute a major portion of the total assets of the company, it may be possible for the company to raise more of long term debts. 11. Purpose of Financing. If funds are required for a productive purpose, debt financing is suitable and the company should issue debentures as interest can be paid out of the profits generated from the investment. However, if the funds are required for unproductive purpose or general development on permanent basis, we should prefer equity capital. 12. Period of Finance. The period for which the finances are required is also an important factor to be kept in mind while selecting an appropriate capital mix. If the finances are required for a limited period of, say, seven years, debentures should be preferred to shares. Redeemable preference shares may also be used for a limited period finance, if found suitable otherwise. However, in case funds are needed on permanent basis, equity capital is more appropriate. 13. Costs of Floatation. Although not very significant, yet costs of floatation of various kinds of securities should also be considered while raising funds. The cost of floating a debt is generally less than the cost of floating equity and hence it may persuade the management to raise debt financing. 14. Personal Considerations. The personal considerations and abilities of the management will have the final say on the capital structure of a firm. Management's, which are experienced and very enterprising and are very enterprising do not hesitate to use more of debt in their financing as compared as the less experienced and conservation management. 15. Corporate Tax Rate. High rate of corporate taxes on profits compel the companies to prefer debt financing, because interest is allowed to be deducted while computing taxable profits. On the other hand, dividend on shares is not an allowable expense for that purpose. 16. Legal Requirements. The Government has also issued certain guidelines for the issue of shares and debentures. The legal restrictions are very significant as these lay down a framework within which capital structure decision has to be made. For example, the controller of capital issues grants his consent for capital issue when (i) the debt- equity ratio does not exceed 2:1 (for capital intensive projects a higher debt- equity ratio does not allowed, (ii) the" ratio of preference capital to equity does not exceed 3:3 and (iii) promoters hold a least 25% of the equity capital. Concept of Balanced Capital Structure Capital structure or financial plan refers to the composition of long-term sources of funds as debentures, long-term debts, preference and ordinary share capital and retained earnings (reserves and surplus). Companies that do not plan their capital structure may prosper in the short run, but ultimately they will face serious problems in raising funds to finance their activities in the long run. Therefore, it is important for a company to take a decision regarding its capital structure. Whenever, financial manager considers the question of capital structure, it is always the question of optimum or balanced capital snoicture i.e., to decide the proportion of ownership funds and borrowed funds. Ownership funds include ordinary and preference share capital and retained earnings (reserves and surplus) and borrowed funds include the amount raised by the issue of debentures, and loans taken from the financial institutions. Optimum- or balanced capital structure means an ideal combination of borrowed and owned capital that may attain the marginal goal i.e., maximising of market value per share or minimisation of cost of capital. The market value will be maximised or the cost of capital will be minimised when the real cost of each source of funds is the same. It is formidable task of the financial manager to determine the combination of the various sources of longterm finance. Characteristics of Balanced Capital Structure A sound capital structure should be devised keeping in view the interests of the ordinary shareholders. However, interests of other groups such as employees, customers, creditors etc. should not be ignored. A sound capital structure should possess the following characteristics.

1. Profitability. The capital structure should be devised in such a way as to maximise the profits of the company keeping in view the burden of the cost of capital on the income of the firm. In order to achieve this objective, a proper policy of trading on equity should be followed. 2. Solvency. A due consideration should be given to the solvency of the company. If a debt threatens the solvency of the company, it should be avoided. 3. Flexibility. The capital structure of a company should be flexible enough to suit the changed conditions. The company should not feel any difficulty in raising funds when they are required or in redeeming them when they are not required any more. Taking this in view Equity shares score over preference shares because there is greater liberty in the payment of dividends on equity shares. Similarly preference shares are preferred to debenture as non-payment of dividends on preference shares is not so serious as non-payment of interest on debentures. Likewise, debentures can be reduced at any time even before maturity under terms of issue. The redemption of preference shares technically does not affect the nature of capital structure. Only composition may be changed. The ordinary shares under no circumstances can be redeemed except under the scheme of reorganization. Thus considering this fact, the capital structure should be as flexible as possible. 4. Conservatism. A company should follow the policy of conservatism while devising its capital structure in the sense that the debt capacity of the company should not be disturbed. In doing so, management should bear in mind the various factors and their effects on its creditability such as value of other securities, issue of securities in future maintenance of product, burden of taxes and future rearrangement of capital structure etc. Such capital structure offers certain decisive advantages to the company, namely, (i) the company's cost of capital is the least; (ii) its prospects of raising capital are good in future even in unfavorable times: and (iii) it can be successful in maintaining healthy relations with security holders. This policy favours for the maintenance of Reserves and surplus at a fairly high figure in a bid to provide guarantee to contributors of funds towards debt paying capacity of the company. 5. Control. Sound capital structure should provide maximum control of the equity shareholders on the company's affairs. 6. Simplicity. A sound capital structure should define clearly the rights attached to each type of securities. It is easy to manage. 7. Economy. Capital mix should be in such a way as to entail the minimum cost of issue of securities and cost of financing etc. 8. Attractiveness of Investors. Securities proposed to be issued should offer certain attractions to the investors either in relation to income, control or convertibility. 9. Balanced Leverage. Both types of securities i.e. ownership and creditor ship, should be issued to secure a balanced leverage. Normally, debentures are issued when-rate of interest is low and shares when rate of capitalization is higher. Objectives of Balanced Capital Structure In devising a sound or balanced capital structure, the manager should bear in mind the following objectives.

A. Economic Objectives 1. Minimization of Costs. Capital cost of various sources of funds is not equal in all circumstances. One of the major objectives of a business enterprise is to raise funds at the lowest possible cost in a given set of circumstances in terms of interest, dividend and the relationship of earnings to the prices of shares. The management should aim at keeping the cost of issue at a minimum to maximise the returns to equity shareholders. 2. Minimization of Risks. Various risks are involved in business operations which have direct bearings on the capital structure of the company such as business risk, management risks, tax risk, trade cycle risks, purchasing power risks, interest rate risk, etc. These risks should be minimised by making suitable adjustments in the components of capital structure. 3. Maximisation of Return. One of the objectives of balanced capital structure is to provide for the maximum return to the real owners (equity shareholders) of the company. It may be achieved by minimising the cost of issue and the cost of financing.

4. Preservation of Control. Generally equity shareholders have the control over the affairs of the company. Preference shareholders and the debentureholders have limited voting rights in matters affecting their interests. The capital structure should be designed as to preserve the control of equity shareholders and to prevent the erosion of control from their hands. It requires proper balance between voting right and non-voting right capital. 5. Proper Liquidity. Liquidity is necessary for the solvency of the company. A proper balance between fixed assets and the liquid assets should be maintained. Nature and size of the business decide the ideal ratio of fixed and liquid assets. 6. Full Utilisation. There must be a proper co-ordination between the quantum of capital and the financial requirements of the business so that full utilisation of available capital may be made at minimum cost. Both the states of undercapitalization and over-capitalisation are unwarranted to the health of industry. Fuller utilisation of capital is also not possible in case of watered capital. Full utilisation of capital requires a fair capitalisation. B) Other Objectives 1. Simplicity. The capital structure should be as simple as possible and conservative too. In the beginning a company should raise only the ownership capital i.e. equity share capital that will enhance the credit of the company. A preference issue may be made if, warranted by the circumstances. 2. Flexibility. The management should design the capital structure very flexible in order to make necessary changes in it whenever required. Management should enjoy the maximum freedom of action to manage the income and capital of the firm. OPTIMAL CAPITAL STRUCTURE As discussed above, the capital structure decision can influence the value of the firm through the cost of capital and trading on equity or leverage. The optimum capital structure may be defined as "that capital structure or combination of debt and equity that leads to the maximum value of the firm" Optimal capital structure maximizes the value of the company and hence the wealth of its owners and minimizes the company's cost of capital' (Solomon, Ezra, The Theory of Financial Management). Thus, every firm should aim at achieving the optimal capital structure and then to maintain it. The following considerations should be kept in mind while maximising the value of the firm in achieving the goal of optimum capital structure: 1. It the return on investment is higher than the fixed cost of funds, the company should prefer to raise funds having a fixed cost, such as debentures, loans and preference share capital It will increase earnings per share and market value of the firm Thus, a company should, make maximum possible use of leverage. 2. When debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. Hence, the effective cost of debt is reduced, called tax leverage. A company should, therefore take advantage of tax leverage. The firm should avoid undue financial risk attached with the use of increased debt financing. It the shareholder perceive high risk in using further debt-capital, it will reduce the market price of shares. The capital, structure should be flexible.

3.

4.

LEVERAGE The financing of capital structure decision is of tremendous significance for the management, since it influences the debt-equity mix of the company, which ultimately affects shareholders' return and risk. In case the borrowed funds are more as compared to the owners' funds, it results in increase in shareholders' earnings together with increase in their risk. This is because the cost of borrowed funds is less than that of the shareholders' funds on account of cost of borrowed funds being allowable as a deduction for income-tax purposes. But at the same time, the borrowed funds carry a fixed interest, which has to be paid whether the company is earning profits or not. Thus, the risk of shareholders increases in case there are a high proportion of borrowed funds in the total capital structure of the company. In a situation where the proportion of the shareholders' funds is more than the proportion of the borrowed funds, the return as well as the risk of the shareholders will be much less.

Meaning of leverage: It is used to describe the firm's ability to use fixed cost assets or funds to magnify the return to its owners. James Home has defined leverage as "the employment of an asset or funds for which the firm pays a fixed cost or fixed return". Thus, according to him leverage results as a result of the firm employing an asset or source of funds, which has a fixed cost (or return). The former may be, termed as "fixed operating cost", while the latter may be termed as "fixed financial cost". It should be noted that fixed costs or return is a fulcrum of leverage. If a firm is hot required to pay fixed cost or fixed return, there will be no leverage. When the volume of sales changes, leverage helps in quantifying such influence. It may, therefore, be defined as relative change in profits due to a change in sales. A high degree of leverage implies that there will be a large change in profits due to a relatively small change in sales and vice versa. Thus, higher is the leverage, higher is the risk and higher is the expected return. TYPES OF LEVERAGES: Leverages are of three types (a) Operating leverage, (b) Financial leverage, and (c) Composite leverage. (a) Operating leverage The operating leverage may be defined as the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales. The firm is said to have a high degree of operating leverage if it employs a greater amount of fixed costs and a small amount of variable costs. On the other hand, a firm will have a low operating leverage when it employs greater amount Of variable costs and a smaller amount of fixed costs. Thus, the degree of operating leverage depends upon the amount the fixed elements in the cost structure. Operating leverage in a firm is a function of three factors: 1. The amount of fixed costs 2. The contribution margin 3. The volume of sales Of course there will be no operating leverage, if there are no fixed operating costs. Computation: The operating leverage can be calculated by the following formula: C Operating Leverage = or Operatingprofit OP Operating profit here means "Earning before interest & Tax" (EBIT) Operating leverage may be favorable or unfavorable. In case the contributions (i.e., sales less variable cost) exceed the fixed cost, there is favorable operating leverage. In a reverse case, the operating leverage will be termed as unfavorable. Degree of operating leverage: The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It may be put in the form of following formula: Percentage change in profits Degree of operating leverage Percentage changes in sales Utility: The operating leverage indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage, small changes in sales will have large effect on operating income. In other words, the operating profits (EBIT) of such a firm will increase at a faster rate than the increase in sales. Similarly, the operating profits of such a firm will suffer a greater loss as compared to reduction in its sales. Generally the firms do not like to operate under conditions of a high degree of operating leverage. This is a very risky situation where a small drop in sales can be excessively damaging to the firm's efforts to achieve profitability. (b) Financial leverage Meaning: The financial leverage may be defined as the tendency of the residual net income to vary disproportionately with operating profit. It indicates the change that take place in the taxable income as a result of Contributbn

change in the operating income. It signifies the existence of fixed interest/fixed dividend bearing securities in the total capital structure of the company. Thus, the use of fixed interest/dividend bearing securities such as debt and preference capital along with the owner's equity in the total capital structure of the company is described as financial leverage. Where in the capital structure of the company, the fixed interest /dividend bearing securities are greater as compared to the equity capital, the leverage is said to be larger. In a reverse case the leverage will be said to be smaller. Favorable and unfavorable financial leverage: Financial leverage may by favorable or unfavorable depending upon whether the earnings made by the use of fixed interest or dividend bearing securities exceed the explicit fixed cost, the firm has to pay for the employment of such funds, or not. The leverage will be considered to be favorable so long the firm earns more on assets purchased with the funds than the fixed costs of their use. Unfavorable or negative leverage occurs when the firm does not earn as much as the funds cost. Trading on equity and financial leverage: Financial leverage is also sometimes termed as "trading on equity". However, most of the authors on financial management are of the opinion that the term trading on equity should be used for the term financial leverage only when the financial leverage is favorable. The company resorts to trading on equity with the objective of giving the equity shareholders a high rate of return than the general rate of earnings on capital employed in the company, to compensate them for the risk that they have to bear. Thus, the financial leverage is a double-edged sword. It has the potentiality of increasing the return to equity shareholders, but at the same time creates additional risk for them. Computation: The computation of financial leverage can be done according to the following methods: I. Where capital structure consists of equity shares and debts: In such a case, financial leverage can be calculated according to the following formula: Financial Leverage = 0P P BT

Where OP = Operating Profit or earning before interest and tax (EBIT) PBT = Profit before tax but after interest. Degree of financial leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in "Operating profit". This may be put in the form of following equation: Degree of financial leverage (DFL) Percentage change in taxable income = Percentage change in operating income 2. Where the capital structure consists of preference shares & equity shares. The formula for computation of financial leverage can also be applied to a financial plan having preference shares. Of course, the amount of preference dividends will have to be grossed up (as per the tax rate applicable to the Co.) and then deducted from the earnings before interest and tax. Utility: Financial leverage helps considerably the finance manager while devising the capital structure of the company. A high financial leverage means high fixed financial costs and high financial risk. A finance manager must plan the capital structure in a way that the firm is in a position to meet its fixed financial costs. Increase in fixed financial costs requires necessary increase in EBIT level. In the event of failure to do so, the company may be technically forced into liquidation. (C) Composite leverage. As explained in the proceeding pages operating leverage measure percentage change in operating profit due to percentage change in sales. It explains the degree of operating risk. Financial-leverage measures percentage change in taxable profit (or EPS) on account of percentage change in operating profit (i.e., EBIT). Thus, it explains the degree of financial risk. Both these leverages are closely concerned with the firm's capacity to meet its fixed costs (both operating and financial). In case both the leverages are combined, the result obtained discloses the effect of change in sales over change in taxable profit (or EPS). Composite leverage thus, expresses the relationship

between revenue on account of sales (i.e., contribution or sales less variable cost) and the taxable income. It helps in finding out the resulting percentage change in taxable income on account of percentage change in sales. This can be computed as follows: Composite leverage = Operating leverage x Financial leverage. C OP OP PBT = C PBT

Where: C = Contribution (i.e. sales variable cost) OP =' Operating Profit or Earning before Interest and Tax PBT = Profit before Tax but after Interest. Significance of operating & financial leverage: The operating leverage and the financial leverage are the two quantitative tools used by the financial experts to measure the return to the owner (viz., earning per share) and the market prices of the equity shares. The management resorts to trading on equity because when there is increase in EBIT then there is corresponding increase in the price of the equity shares. However, a firm can not go indefinitely in raising the debt content in the total capital structure of the company. If a firm goes on employing greater proportion of debt capital the marginal cost of debt will also go on increasing because the subsequent lenders will demand higher rate of interest. The company's inability to offer sufficient assets and security will also stand in the way of further employment of debt capital. Moreover, a firm with widely fluctuating income can not afford to employ a high degree of financial leverage. A company should try to have a balance of the two leverages because they have got tremendous acceleration or deceleration effect on EBIT and EPS. It may be noted that a right combination of these leverages is a very big challenge for the management. A proper combination of both operating and financial leverage is a blessing for the firm's growth while an improper combination may prove to be a curse. A high degree of operating leverage together with a high degree of financial leverage makes the position of the firm very risky. In case the earnings fall the firm may not be in a position to meet its fixed costs. Moreover, greater fluctuations in earnings are likely to occur on EBIT-EPS ANALYSIS In the previous chapter, the relationship between the change in sales level and the change in EPS was analyzed with reference to the leverage analysis. There is another way to analyze the impact of leverage on the return available to the shareholders. Given a particular-level of EB1T, what will be the level of return available to shareholders under varying conditions of financing? There may be different firms which are operating under similar conditions and having same level of EBIT and are alike in all respects accepts the pattern of financing. Whether, these firms will have same return for the shareholders? This analysis of the effect of different patterns of financing or the financial leverage on the level of returns available to the shareholders, under different assumptions of EBIT is known as EB IT-EPS analysis. The present chapter attempts to analyze the EBIT-EPS relationship under varying conditions and assumptions. A firm has various options regarding the combinations of various sources to finance its investment activities. The firms may opt to be an all-equity firm (and having no borrowed funds) or equity-preference firm (having no borrowed funds) or any of the numerous possibility of combinations of equity, preference shares and borrowed funds. However, for all these possibilities, the sales level and the level of EBIT is irrelevant as the pattern of financing does not have any bearing on the sales or the EBIT level. In fact, the sales and the EBIT level are affected by the investment decisions. So, the emphases in the present chapter are only on the effect of financing patterns on the returns available to the shareholders. The financing pattern will definitely affect the apportionment of the EBIT over different elements and in particular, affect the returns to the shareholders. This is due to the fact that different combinations of equity, preference share and debt financing have different costs and tax implications. Given a level of EBIT, a particular combination of different sources of finance will result in a particular EPS and therefore, for different financing patterns, there would be different levels of EPS. Moreover, the EBIT level may also change due to one or the other reason. Thus, an interaction between the varying levels of EBIT and the

financing patterns can affect the EPS in more than one ways. This and other implications of the financing patterns can be studied as EBIT-EPS analysis under two cases as follows: CONSTANT EBIT AND CHANGE IN THE FINANCING PATTERNS : Holding the EBIT constant while varying the financial leverage or financing patterns, one can imagine the firm increasing its leverage by issuing bonds and using the proceeds to redeem the capital, or doing the opposite to reduce leverage. In practice, firms do not vary their leverage in this way. Usually the proceeds of new issue (of debts) are invested in assets rather than using to retire other capital liabilities. The effect on the EPS of a change in leverage while holding the EBIT constant has been analyzed in the following discussion. VARYING EBIT WITH DIFFERENT PATTERNS: The assumption of constant EBIT (as taken in the above case) is unrealistic and imaginary. In practice, a firm may not able to correctly estimate the EBIT level whatsoever thorough analysis might have been made in this respect. The EBIT level may vary and the actual EBIT may come out to be different than the expected one. Therefore, the effect of financial leverage on the EPS should be analyzed under the assumption of varying EBIT also. The following example will illustrate this point. FINANCIAL BREAK-EVEN LEVEL: In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then such level of EBIT is known as financial break-even level. For example, in the above case, the financial breakeven level for firm Y & Co. is Rs. 6,000 and for Z & Co. the financial break-even level is Rs. 9,000 (i.e., just equal to their interest charges respectively). Thus, the financial break-even level is such a level of EBIT at which only the fixed financial charges of the firm are covered and consequently the EPS is zero. If the EBIT reduces below this financial break-even level, the EPS will be negative. The financial break-even level of EBIT may be calculated as follows: If the firm has employed debt only (and no preference shares), the financial break-even EBIT level is: Financial break-even EBIT = Interest Charge If the firm Has employed debt as well as preference share capital, then its financial break-even EBIT will be determined not only by the interest charge but also by the fixed preference dividend. It may be noted that the preference dividend is payable only out of profit after tax, whereas the financial break-even level is before tax. The financial break-even level in such a case may be determined as follows: Financial break-even EBIT = Interest Charge + Pref. Div./(l-t) INDIFFERENCE POINT/LEVEL: The indifference level of EBIT is one at which the EPS remains same irrespective of the debt-equity mix. While designing a capital structure, a firm may evaluate the effect of different financial plans on the level of EPS, for a given level of EBIT. Out of several available financial plans, the firm may have two or more financial plans which result in the same level of EPS for a given EBIT. Such a level of EBIT at which the firm has two or more financial plans resulting in same level of EPS, is known as indifference level of EBIT. The use of financial break-even level and the return from alternative capital structures is called the indifference point analysis. The EBIT is used as a dependent variable and the EPS from two alternative financial plans is used as independent variable, and the exercise is known as indifference point analysis. The indifference level of EBIT is a point at which the after tax cost of debt is just equal to the ROI. At this point the firm would be indifferent whether the funds are raised by the issue of debt securities or by the issue of share capital. The following example will illustrate this point.