| "After heavy financial crunches in the economy, for a | | | | the capital structure. |
| corporate entity, it is quite significant to have a | | | | Capital gearing is calculated by determining the ratio |
| perfect blend of various capital sources to ensure | | | | between the amount of equity capital (representing |
| good returns and overcome from the depth of | | | | variable income bearing securities) and the total |
| losses." | | | | amount of securities (equity shares, preference |
| Here, some crucial terms have been defined with | | | | shares and debentures) issued by a company. Here |
| reference to the financial system of a company: | | | | capital structure of two different companies is |
| CAPITAL STRUCTURE | | | | presented. Both the companies have issued the total |
| The types of securities to be issued and | | | | securities worth Rs. 20,00,000 and they have equity |
| proportionate amounts that make up the | | | | shares worth Rs. 5,00,000 and Rs. 15,00,000 |
| capitalization is known as capital structure or financial | | | | respectively. Company A is highly geared as the ratio |
| structure. | | | | between equity capital to total capitalization is small, |
| Capital structure refers to the proportion of different | | | | i.e., 25%. But in case of company B, this ratio is 75%, |
| kinds of securities issued by a company to raise | | | | so it is low geared. |
| long-term finance. Thus capital structure denotes: (1) | | | | ANALYSIS OF CAPITAL GEARING |
| the types of securities issued (equity shares, | | | | Company |
| preference shares and debentures), and (ii) the | | | | (Rs.) |
| relative proportion of each type of security. In other | | | | (a) Equity share capital 5,00,000 |
| words, capital structure represents the proportion of | | | | (b) Debentures 15,00,000 |
| equity capital and dept capital used for financing the | | | | (c) Total Capitalisation 20,00,000 |
| operations of a business. Proper balance must be | | | | (d) Capital Gearing (a /c × 100) = 5,00,000/ |
| obtained in the following securities or sources of | | | | 2,00,000×100 |
| finance to maximize the wealth of the equity | | | | = 25% (High Gearing) |
| shareholders of the company: | | | | The various securities issued should bear such ratio to |
| (a) equality shares, | | | | total capitalization that capital structure is safe and |
| (b) preference shares, and | | | | economical. |
| (c) debentures | | | | Equity shares should be issued where there is |
| Features of Sound Capital Structure | | | | uncertainty of earnings. Preference shares, particularly |
| A company's capital structure is said to be optimum | | | | the cumulative ones, should be issued when the |
| when the proportion of debt and equity is such that | | | | average earnings are expected to be fairly good. |
| it results in maximizing the return for the equity | | | | Debentures should be issued when the company |
| shareholders. Such a structure would vary from | | | | expects fairly higher earnings in future to pay interest |
| company to company depending upon the nature and | | | | to the debenture-holders and increase the return of |
| size of operations, availability of funds from different | | | | equity shareholders. |
| sources, efficiency of management, etc. | | | | TRADING ON EQUITY |
| A SOUND CAPITAL STRUCTURE SHOULD POSSESS | | | | Trading on equity is an arrangement under which the |
| THE FOLLOWING FEATURES: | | | | financial management raises funds by issuing |
| (i) MAXIMUM RETURNS. | | | | securities which carry a fixed rate of interest (or |
| (ii) LESS RISKY. | | | | dividend) which is less than the average earnings of |
| (iii) FLEXIBILITY | | | | the company. This is done to increase the return on |
| (iv) ECONOMY. | | | | equity shares. |
| (v) DYNAMIC. | | | | Let us suppose that a company requires an |
| FINANCIAL LEVERAGE OR CAPITAL GEARING | | | | investment of Rs. 10 Lakhs to earn Rs. 2.5 lakhs @ |
| A company can raise capital by issuing three types of | | | | 25 per cent p.a. In order to raise this amount, we |
| securities: (a) equity shares, (b) preference shares, | | | | may consider two proposals, namely, (A) to issue 1 |
| and (c) debentures. Preference shares carry a fixed | | | | lakhs equity shares of Rs. 10 each: and (B) to issue |
| rate of dividend and debentures carry a fixed rate of | | | | equity shares worth Rs. 2.5 lakhs (i.e., 25,000 shares |
| interest. The equity shares are paid dividend out of | | | | of Rs. 10 each), 8 % preference shares worth Rs. 2.5 |
| profits left after payment of interest on debentures, | | | | lakhs, and 10 per cent debentures worth Rs. 5 lakhs. |
| and dividend on preference shares. Thus, dividend on | | | | The rate of tax is assumed to be 40 per cent. The |
| equity shares may vary year after year. Equity | | | | earnings per share under proposal 'B' will be higher |
| shares are known as variable return securities and | | | | because of application of 'trading on equity'. As |
| debentures and preference shares as fixed return | | | | shown in the following table, the earnings per share |
| securities. If the rate of return on fixed return | | | | (EPS) under proposal B are Rs. 4.00 as compared to |
| securities is lower than the rate of earnings of the | | | | Rs. 1.50 under Proposal A because of the use of |
| company, the return on equity shares will be higher. | | | | debentures and preference capital for raising funds. |
| This phenomenon is known as financial leverage or | | | | EFFECT OF TRADING ON EQUITY |
| capital gearing. | | | | - Particulars Proposal |
| Thus, financial leverage is an arrangement under | | | | - Earning before Interest and Taxes (EBIT) Rs. |
| which fixed return bearing securities (debentures and | | | | 2,50,000 |
| preference shares) are used to raise cheaper funds | | | | - Less Interest on Debentures (10%) Nil |
| to increase the return to equity shareholders. It may | | | | - Earning after interest and before Taxes 2,50,000 |
| be noted that a lever is used to lift something heavy | | | | - Less Taxes (40%) 1,00,000 |
| by applying less force than required otherwise. | | | | - Earning after Interest and Taxes 1,50,000 |
| Capital gearing denotes the ratio between various | | | | - Less Preference Dividend (8%) Nil |
| types of securities and total capitalisation. | | | | - Earning available to Equity Shareholders 1,50,000 |
| Capitalisation of a company is highly geared when the | | | | - No. of Equity shares outstanding 1,00,000 |
| proportion of equity to total capitalization is small and | | | | - Earning per share (EPS) Rs. 1. |
| it is low geared when the equity capital dominates | | | | |