A capital structure is the way a corporation finances it assets through a combination of Equity Shares, Preference Shares, Short term loans or Long term loans. This gives a detail analysis of the borrowings and the shareholder’s fund available with the company.
The capital structure analysis is done to know how much a company owes as to interest, dividends and how much it earns per share after paying out all the financial expenses. It is important for a company to have an optimal capital structure which minimizes its interest expense and increase the earning per share. The basic focus is on maximizing the earnings per share (EPS) because that is the basic aim of the company’s functions.
The following could be a part of the capital structure of a company:
1. Debentures: Debentures are the borrowings taken from the public in lieu of some asset being mortgaged. These are long term securities issued by company and are secured against some assets. They always carry some interest charge. When it comes to distribution of profits; the interest to debenture is paid first. In case of winding up too, the debentures are given priority over the shareholders.
2. Other Borrowings: For the financing purpose, the companies can borrow amount from the other sources of finance a well such as Banks, Financial Institutions etc. They also carry some interest charge and enjoy a priority over the shareholders.
3. Preference Shares: The preference shares are the shares which carry some preferential right such as right to dividend and right to be paid before equity shares in the time of winding up.
4. Equity Shares: The equity shareholders are regarded as the real owners of any business. The equity holders always get paid at the last. They don’t get any dividend but have voting rights for taking the decision in the business. In times of winding up whatever is left after paying out all the liabilities and preference shareholders; the amount is distributed among the equity share holders.
|Earnings before Interest and Tax (EBIT)||XXX|
|Less: Interest on Borrowings||(XXX)|
|Earnings before Tax (EBT)||XXX|
|Earnings after Tax (EAT)||XXX|
|Less: Preference Dividend||(XXX)|
|Earnings available for Equity Shareholders (EAE)||XXX|
|÷ Number of Equity Shares||XX|
|Earnings per share (EPS)||X|
Point of Indifference: The point of difference is referred to that level of EBIT where even after changing the debt-equity mix, the EPS remains constant i.e. does not changes.
I1: Interest on the borrowings in first alternative. I2: Interest on the borrowings in second alternative. t: Tax Rate. PD: Preference Dividend. N1: Number of equity shares in first alternative. N2: Number of equity shares in second alternative.
There are 4 different capital structure theories each based on a certain set of assumptions.
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It is very important to have an optimal capital structure in the business. It is the capital structure that will determine the dependence of the company to external forces and how much borrowing cost it will be incurring. Thus it is very necessary to have an optimal structure which consists of a mix of all forms of sources of finance. It will not create a situation of Trading on Equity or Retaining Control.
1. Solvency: The capital structure should be designed in such a way that it ensures of the firm not running into debts and finally becoming insolvent. It has to take care of the debt equity ratio in the company such that at any time the company is capable of paying its debts.
2. Flexible: The Capital Structure so obtained must be dynamic in nature. It should be designed in such a way that it can be easily maneuvered whenever required as per the requirements of the company. It must not be rigid.
3. Profitable: The optimal capital structure will be the one which earns the company the maximum profit and increases the earnings per share. Increasing the EPS is the main aim of the company.
4. Control: The Capital Structure must not be formed in a way that it loses the control on the functions of the company. Bringing in a large number of equity shareholders will increase the controlling heads in the business and the business functions will be hindered.
5. Conservatism: The capital structure must be prudent in nature. It must be formed with taking in consideration the principle of conservatism such that more and more outgoing flow of finance must be obscured.
The applications of Capital Structure and the implementation of its theories in relation to the determination to the Value of firm could be complicated to understand. But you can have access to our online classes where the best teachers are available to teach you topics. You have the choice to choose the teacher you want to study from. Visit assignmenthelp.net and have a look at the sample assignments.
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