Capital structure

By: Sakshi Sachdeva

 Financing decisions
• The Financing Decision is yet another crucial
decision made by the financial manager
relating to the financing-mix of an
organization. It is concerned with the
borrowing and allocation of funds required for
the investment decisions.
Trading on Equity
Meaning of Trading on Equity
When a company uses fixed interest bearing capital along with
owned capital in raising finance, is said “Trading on Equity”.
(Owned Capital =Equity Share Capital + Free Reserves )
Trading on equity represents an arrangement under which a
company uses funds carrying fixed interest or dividend in such a
way as to increase the rate of return on equity shares.

Definitions:
In words of Gerstenberg, “When a person or a corporation
uses borrowed capital as well as owned capital in the
regular conduct of its business, he or she is said to be
trading on equity”

While Guthmann and Dougall have said, “the use of borrowed

funds or preferred stock for financing is known as trading
on equity.”
 Capital Structure
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders’ wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders’ expectations
(risk & returns) and capital requirements of the firm.
 Factors affecting capital structure
• Financial leverage • Capital market conditions
• Growth of sales • Assets structure
• Cost of capital • Corporate tax rate
• Risk
• Cash flow ability
• Nature and size of firm
• Control
• Flexibility
• Requirement of investors
 Patterns of capital structure
• Equity shares only
• Equity and preference shares
• Equity shares and debentures
• Equity shares, preference shares and
debentures
 EBIT-EPS ANALYSIS
• ABC company has currently an all equity capital structure
consisting of 20000 equity shares of Rs. 100 each. The
management is planning to raise another Rs. 30 lakh to
finance a major prog of expansion and is considering three
alternative methods of financing:
• To issue 30000 equity shares of Rs. 100 each
• To issue 30000, 8% debentures of Rs. 100 each
• To issue 30000, 8% preference shares of Rs. 100 each
The company’s expected earnings before int and taxes will be
Rs. 10 lakhs. Assuming a corporate tax rate of 50%,
determine the earnings per share in each alternative and
comment which alternative is best and why?