Prof. Vipin Agarwal
Capital structure decisions aims at determining the types of funds a company should seek to finance its investment opportunity and the preparation in which these funds should be raised. The term capital structure is used to represent the proportionate relationship between the various long-term forms of financing such as debentures, long term debts, preference share capital and equity share capital. ‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it also means ‘effectiveness’ or ‘power’. The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature of financial leverage. When an organization is planning to raise its capital requirements (funds), these may be raised either by issuing debentures and securing long term loan or by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raised from debts, the Company will pay interest, which is a definite liability of the company. Whether the company is earning profits or not, it has to pay interest on debts. But one benefit of raising funds from debt is that interest paid on debts is allowed as deduction for income tax. ‘When funds are raised by issue of shares (equity) , the investor are paid dividend on their investment. Dividends are paid only when the Company is having sufficient amount of profit. In case of loss, dividends are not paid. But dividend is not allowed as deduction while computing tax on the income of the Company. In this way both way of raising funds are having some advantages and disadvantages. A Company has to decide that what will be its mix of Debt and Equity, considering the liability, cost of funds and expected rate of return on investment of fund. A Company should take a proper decision about such mix, otherwise it will face many financial problems. For the purpose of determination of mix of debt and equity, leverages are calculated and analyzed. Lets take an example to understand the whole concept of leverage:- There is a pharmaceutical company named XYZ Pvt. Ltd. Company is facing competition from other players in the market, due to this company decided to expand their business to compete with others and to sustain in market. Company launched a new drug, for this company required a huge amount of capital to invest for laboratory, marketing, production etc. First company decide their source of funds, or from where do they raise their capital. So, company do analysis for this. They prepare capital structure with different mode. They are:- Capital Structure:- 1Capital structure:-2
Interest rateInterest rate
Owners equity- 50000Owners equity-20000
Equity shareissue-25000 (7%)equity share issue-55000 (7%) Debt-5000 (10%)debt-10000 (10%) Bonds-10000 (12%)bonds-5000 (12%) Total 900003250Total 90000 5350
All monetary values are in Rs.
From the above two capital structure we can see in 1st structure company have to give Rs. 3250 as interest and in 2nd structure company have to pay Rs. 5350, but company select 2nd one because owners capital is not free of cost. If interest is paid on capital then it will deducted from tax payable money, and company have to pay lesser amount of tax. To determine the fixed operating cost and fixed financial cost company do calculate operating and financial leverage. Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage...