Various financial ratios are used to analyze the capital structure of a firm. These can give investors and analysts a view of how a company compares with its peers and therefore its financial standing in its industry. If the overleveraged company’s particular business sector is extremely competitive, competing companies could take advantage of its position by swooping in to grab more market share. With leverage, the assumption is that management can earn more using borrowed funds than what it would pay in interest expense and fees on them. However, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its various borrowing commitments.
The Securities and Exchange Commission conducts an oversight study of credit rating agencies annually on behalf of investors. This article focuses on analyzing a company’s capital structure portion of the balance sheet. There are two types of capital structure according to the nature and type of the firm, viz, (a) Simple and (b) Complex. Organisation prefers to be highly geared during inflation period because the earnings will be more.
So capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised. The money so raised can then be applied in providing equipment during the ensuing depression while the prices of materials and labour are low. It is necessary to avoid over-issue of preference shares and debentures unless high gearing is considered desirable. Low gearing of capital, on the other hand, takes place when the proportion of equity capital to the total capital is high or when the proportion of fixed cost capital to the total capital is small. Thus we can conclude that capital gearing has an important bearing on the profitability of the concern. In fact, the entire policies concerning the division of capital structure and administration of the capital are based on the use of capital gears.
If the EBIT is high from EPS point of view, debt financing is preferable to equity. When the ROI is more than the interest on debt, debt financing increases ROE. Capital structure of a company is also affected by the purpose of financing.
If the company had raised the entire capital by the issue of equity shares, it cannot pay more than 10 per cent as dividend, or more than Rs.1,00,000. However, on borrowings, interests are to be paid whether or not there are profits. Similarly, on the preference capital too, the dividends have to be paid at a fixed rate out of profit, but before the equity shareholders are paid any dividends. It refers to the additional profit which equity shares make at the cost of other types of securities. It is based on the theory that there is a difference among the rates of return on different types of securities issued by the company. Thus, the cost of capital curve may be V-shaped which shows that application of additional debt in capital structure beyond a point will result in an increase in total cost of capital and drop in market value of the firm.
- In the first phase, the overall cost of capital declines with financial leverage because the rise in cost of equity does not entirely offset the benefit incurred by using the cheaper fixed cost debt.
- In other words, the decisions of capital structure affect the value of the firm by the returns that are made available for the equity shareholders.
- An agency, such as Moody’s or Standard & Poor’s, rates the debt according to a company’s ability to pay principal and interest to the debt holders.
The second phase contains the only point at which the benefits of using cheaper debt are entirely offset by rise in the cost of equity. Figure 3 shows how the cost of equity capital and overall cost of a firm responds to varying degrees of financial leverage. One view states that the value of the firm depends on the capital structure in-turn it emphasises on the cost of capital.
The Problem With Too Much Leverage
This can signify that a company is relying too much on its equity and not making efficient use of its assets. Investment literature often equates https://1investing.in/ a company’s debt with its liabilities. However, there is an important distinction between operational liabilities and debt liabilities.
Capital Structure: Meaning, Assumptions and Classification Accounting
In other words, there should be a proper proportion between the amount raised by equity shares which carry variable rates of return and the amount raised by preference shares and debentures which carry a fixed rate of return. A company, by issuing debentures and preference shares, can substantially increase the dividend rate for the equity shareholders. On the other hand, the dividend rate cannot go beyond the general earning, if the entire capital is raised by the issue of equity shares. The return on the equity capital is then lower than the average rate of the overall earnings. Thus by issuing preference shares and debentures in large proportion, the rate of dividend on equity shares can be considerably increased.
A highly geared company can pay a higher dividend to its equity shareholders. The higher the gear is the more attractive and speculative would be the equity shares. The ratio which the different types of the securities bear to the total capitalization means “gearing”.
Factors Determining Capital Structure:
There is neither an advantage nor a disadvantage in using debt in a firm’s capital structure. The primary credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. These entities conduct formal risk evaluations of a company’s ability to repay principal and interest on debt obligations, primarily on bonds and commercial paper.
Bluebonnet Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million. It has one million shares of stock, which are trading for $15 per share. Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. On the other hand, equity represents a claim by the owner on the future earnings of the company.
This can also be done by incorporating long-term debt capital in the capital structure as the cost of debt capital is lower than the cost of equity or preference share capital since the interest on debt is tax deductible. Moreover, a company has to pay tax on the amount distributed as dividend to the equity shareholders. Due to this, total earnings available for both debt holders and stockholders is more when debt capital is used in capital structure. Therefore, assumptions of capital structure if the corporate tax rate is high enough, it is prudent to raise capital by issuing debentures or taking long-term loans from financial institutions. Thus, with the issue of debentures and preference shares at fixed rates of interest and dividend, the rate of dividend to equity shareholders is substantially increased. Besides, as interest on borrowed funds is allowed by income-tax authorities as a deductible expense, there can be saving in income-tax.
Such expenditure may be incurred out of funds raised by share issue or still better out of retained earnings. Borrowing should be used only for purposes of financing definite productive projects. It is a mistake to believe that if a company is incurring losses, the situation can be remedied by raising funds through borrowing or through issue of shares.
Analyzing a Company’s Capital Structure
So, a firm will have to use a variety of securities in order to appeal to various types of investors. The capital structure is made up of debt and equity securities which comprise a firm’s finance of its assets. It is the permanent financing of a firm represented by long-term debt, plus preferred stocks and net worth. In other words, the decisions of capital structure affects the value of the firm by the returns that are made available for the equity shareholders. On the other hand, leverage affects the value of the firm by the cost of capital. The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure.