Capitalisation, capital structure and leverage analysis.pptx module 3

financial management

1. Capitalisation, capital structure and leverage analysis

2. Capitalisation It comprises a corporations ownership capital and its borrowed capital represented by its long term indebtedness.

3. Over capitalisation Simply means that the companys earnings are consistently inadequate to earn a fair rate of return on the capital employed The company fails to pay interest on debt, dividend etc Market price is low Real value of asset is less than the book value

4. Causes of over capitalisation Raising excessive capital Purchase of assets during inflationary situations High promotion expense Defective depreciation policy Liberal dividend policy High rate of interest Rigourous taxation

5. Consequences of over capitalisation To shareholders: Reduced dividends Fall in market price Liquidation of business Shares become unacceptable

6. To the company: Loss of goodwill Loss of creditworthiness Manipulation of accounts Lack of competitive strength

7. To the creditors: Default in payment of interest and principal amount To the employes : Wage cuts and retrenchments To the society: Poor quality product with higher price Less employment opportunities

8. Remedies of over capitalisation Redemption of pref. shares having high rate of dividend Repayment of longterm loans having high rate of interest Fresh borrowings at low interest Increasing the efficiency of management

9. Under capitalisation The actual return of the company is higher than the fair rate of return The current value of assets exceeds the book value of assets High rate of dividend

10. Causes of under capitalisation Under estimation of capital requirements Under estimation of future earnings Promotion during recession Conservative dividend policy Desire of control Efficient management

11. Consequences of under capitalisation Management try to conceal the real profits by creating secret reserves Increases tax burden Creditors will demand a high rate of interest Attract new entrants Will ends up in over capitalisation

12. Remedies of under capitalisation Issue of fresh shares Bonus issue increase the marketability of shares Adopt a liberal dividend policy Buy back of shares

13. Capital structure The ratio of equity capital and debt capital in the capitalisation is known as capital structure. It shows the proportion of various owned funds and borrowed funds

14. Patterns of capital structure Equity shares only Equity shares and retained earnings Equity , retained earnings and pref shares Equity, retained earnings and debentures Equity , retained earnings , preference shares and debentures

15. Optimum capital structure Defined as the capital structure that maximises the value of the firm so that the overall cost of capital is at its minimum The market price of shares will be at its maximum The weighted average cost of capital at its minimum EPS will be at its maximum

16. Factors affecting capital structure Trading on equity Cost of capital Flexibility Desire for control Nature of the business Cash flows

17. Size of the business Purpose of financing Period of financing Market sentiments Government policy Corporate taxation Floatation cost

18. Importance of capitalisation Value maximisation Cost minimisation Capital budgeting Dividend decisions Working capital decisions Claims of suppliers of funds

19. Leverage analysis In financial management , leverage refers to the firms ability to use fixed cost assets or fixed cost funds to magnify the return of its owners. There are three types of leverage : Operating leverage Financial leverage Composite leverage

20. Operating leverage Operating leverage is that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage OL= Contribution = sales – variable cost Degree of operating leverage= % change in EBIT/ % change in sales BEP = fixed cost / PV ratio  

21. Financial leverage Defined as the use of long term fixed interest bearing securities and preference shares along with equity share capital inorder to magnify the earnings of equityshareholders FL= EBIT/ EBT DFL= % change in EPS/ % change in EBIT

22. Significance of financial leverage Capital structure planning Profit planning EPS maximisation Reduction of overall cost of capital

23. Limitations of FL Double edged weapon Good only for stable companies Restriction from financial instituitions Increases the financial risk Increase in rate of interest

24. Operating leverage vs financial leverage

25. Composite leverage Combined leverage is a leverage which refers to high profits due to fixed costs. CL = operating leverage * financial leverage ie : Contribtion / EBT DCL = % change in EPS / % change in sales