TOPIC 5-Cap Stru&Divi Poli

8/8/2019 TOPIC 5-Cap Stru&Divi Poli

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IntroductionIntroduction

Capital structure of a

company refers to the

composition or make of itscapitalisation and it includes

all long-term capital

resources viz., loans,reserves, shares and

debentures.


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Capital structure is a relationship

between the various long-term

form of financing such asdebenture, preference share

capital and equity share capital

Forms of capital structure:It may consists of

- Equity shares only

- Equity and Preference shares

- Equity and debentures

- Equity, preference shares and

debentures


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Optimum Capital Structure:Optimum Capital Structure:

Capital Structure influences

the value of the firm through

the cost of capital and tradingon equity or leverage.

Combination of Debt and

Equity that leads to maximum

value of the firm.


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Consideration for maximizing the firmvalue;

- If the return is more than fixed cost,

better to prefer fixed cost funds like

debentures, loans and preference

capital.- When debt is used as a source of

finance, the firm saves considerable tax

benefit.

- The capital structure should be flexible.


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Effect of Financial Plan on EPS andEffect of Financial Plan on EPS andROE: Constant EBITROE: Constant EBIT

The firm is considering two alternativefinancial plans:

(i) either to raise the entire funds byissuing 50,000 ordinary shares at Rs 10

per share, or

(ii) to raise Rs 250,000 by issuing 25,000ordinary shares at Rs 10 per share and

borrow Rs 250,000 at 15 per cent rate ofinterest.

The tax rate is 50 per cent.


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Financial Plan

All-Equity

(Rs)

Debt-Equity

(Rs)

1. Earnings before interest and taxes, EBIT 120,000 120,000

2. Less: interest, INT 0 37,500

3. Profit before taxes, PBT = EBIT INT 120,000 82,500

4. Less: Taxes, T (EBITINT) 60,000 41,250

5. Profit after taxes, PAT = (EBIT INT) (1

T)

60,000 41,250

6. Number of ordinary shares,N 50,000 25,000

7. EPS = (EBIT INT) (1 T)/N 1.20 1.65

8. ROE = (EBIT INT) (1 T)/S 12.0% 16.5%

Effect of Financial Plan on EPS andEffect of Financial Plan on EPS andROE: Constant EBITROE: Constant EBIT


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Theories of Capital StructureTheories of Capital Structure

The important theories are;

1. Net Income approach (NI)

2. Net Operating Incomeapproach (NOI)

3. The Traditional approach

4. Modigliani and Millerapproach (MM)


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Pecking Order TheoryPecking Order Theory

Internal Finance Debt Finance

External Equity Finance

Firms use internally generated funds first,

because there are no flotation costs or negativesignals.

If more funds are needed, firms then issue debtbecause it has lower flotation costs than equity

and not negative signals.

If more funds are needed, firms then issueequity.


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Capital structureCapital structure FRICT AnalysisFRICT Analysis

Flexibility

Risk

Income Control

Timing


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7. Flexibility

8. Requirements ofinvestors

9. Capital market conditions10.Asset structure

11.Purpose of financing

12.Period of finance

13.Avail tax liability

Factors determining the capital structure:Factors determining the capital structure:


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Capital structure in practice:

Nature of Industry Capital structureElectrical Debt-equity less than 2:1

Chemical Conservative debt policy only for

expansion policy

Tea Internally generated funds

Fertilizer No specific type of debt or equity

Automobile Debt-Equity usually of 2:1

Pharmaceuticals Conservative policy of 1.7:1Consumer Focus on technology & production

electronics


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Meaning:Meaning:

The term dividend refers tothat part of profits of a

company which distributed by

the company among its

shareholders.

It is the reward of the

shareholders for investment

made by them in the shares of

the company.


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Dividend is Financing orDividend is Financing or

Investment Decision?Investment Decision?

Dividend decision is part of

Financing decision, because the

earnings available may beretained in the business for Re-

investment. If the funds are not

required, they may distributed asdividends.


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Affects:Affects:

Dividend policy of the firm affect

both the long-term financing

and wealth of the

shareholders. Therefore, thefirm distribute;

- reasonable amount as dividend

to its members,- retain the rest for its growth &

survival.


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Dividend Decision:Dividend Decision:

Acc. to one school of thought

dividend decision does not affect

the shareholders wealth.

Acc. to another school of

thought, dividend decision affectthe shareholders wealth.

Based on these two thoughts, it

can be classified into two

theories.

1. Relevance Theory

2. Irrelevance Theory


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Determinants of Dividend policy:Determinants of Dividend policy:

1. Legal restrictions2. Desire and type of shareholders

3. Nature of Industry

4. Age of the company

5. Future financial requirements6. Taxation policy

7. Control objectives

8. Requirements of institutional

investors.9. Liquidity position of the firm

10. Cost of external equity andretained earnings.


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Dividend Policy:Dividend Policy:

1. Stable dividend policy: Acc. to this,the percentage of earnings paid out

as dividends remains constant. Sothat, dividends fluctuate in line withearnings.

Earnings

Time

Dividend

Earnings


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2. Steadily changing dividend:2. Steadily changing dividend:

As per this policy, the rupee levelof dividends remains stable or

gradually increase or decreases.Earnings

Time

Dividend


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TOPIC 5-Cap Stru&Divi Poli