Capital Structure

Financial leverage indicates borrow of funds to raise the capital by issuing shares in the market to meet their business requirements. This also indicates the profitability and return on equity of the company which has taken significant amounts of debt. The financial leverage has many advantages but it possess some limitations as well which has been shown as follows:-

1) When a company borrows funds using financial leverage then this money develops an environment that can either creates lots of profits or a small amount of it.

2) Borrowing constantly creates an image that the company might be on high risk. Which in turn increases the interest rates and some restrictions could be handed over to the borrowing organization.

3) Value of stock also gets affected as it can drop substantially if the stockholders intervene in between.

Financial leverage is the leverage in which a company decides to finance majority of its assets by taking on debt. The leverages have been applied by investors and companies to generate more returns on their assets. This employment of leverage doesn't guarantee success and increases the possibility of excessive losses which becomes more great in high leverage positions. Firms use this leverage when they are unable to raise enough capital by issuing shares in the market and unable to meet their business needs. When firm takes on debt it sees that at that time how is the return on assets and for a firm it should be higher than the interest on the loan.

How is it calculated?

The calculation of financial leverage takes place in following steps:-

1) Calculation of total debt is carried out by the company which includes short term debt as well as long term debt.

2) Calculation of total equity takes place in the company by shareholders to find out the equity they multiply number of outstanding shares by stock price. This amount is represented as shareholder equity.

3) To calculate financial leverage ratio divide total debt with total equity.

4) If company has high financial leverage ratio than it could be a sign of financial weakness. This can also lead to bankruptcy if the company is highly leveraged.

Modigilani-Miller approach is also known as MM approach which looks similar to Net operating income approach. It is in synchronization with the Net operating income approach and states in acceptance with the approach that cost of capital is independent of degree of leverage. It provides justification for operational and behavioural for constant cost of capital at any degree of leverage as this is not being provided by the Net operating Income approach. It is been assumed in this approach that capital markets are perfect and the investors are investing in the company from the same expectation of the company's net operating income in search of evaluating the value of the firm. The propositions of this approach can be mentioned in the following ways and it is as follows:-

1) Company's overall cost of capital and value of the firm is constant at any degree of leverage as it is independent of the capital structure.

2) Capital investment which has the minimum cut-off rate is also independent of project finances.

If this approach has advantages then it has certain limitations associated with it and the limitations are as follows:-

1) Investors find the leverages inconvenient and risk perception of corporate and personal leverage is different.

2) Corporate doesn't exist but it gets removed later.

3) Arbitrary process doesn't have any restrictions and it is also not be affected by transaction cost.

Capital structure is a term which is referred to be the mix of sources from which the long term funds are required for business purposes which are raised to improve the capital of the company. The theories which are involved in these are as follows:-

1) Net operating income (NOI):- this is an approach in which both value of the firm and weighted average cost are independent of capital structure. Individual holding the debt and equity receives the same cash flows without worrying about the taxes as they are not involved in it.

2) Traditional approach and Net income (NI) approach :- this is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and don’t depend on how much debt the firm is using.

3) MM hypothesis with and without corporate tax : This approach tells that firm's value is independent of capital structure. The same return can be received by shareholders with the same risk.

4) Miller’s hypothesis with corporate and personal taxes : This approach gives important advantage over equity. This ignores bankruptcy and agency costs.

5) Trade-off theory: costs and benefits of leverage.

Net income (NI) approach as this is also called as traditional approach. This is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and doesn't depend on how much debt the firm is using. This theory was proposed by David Durand. In this change in financial leverage leads to change in overall cost of capital as well as total value of firm. If financial leverage increases, weighted average cost decreases and value of firm and market price of equity increases. If this decreases then weighted average cost of capital increases and value of firm and market price of equity decreases. The assumptions which can be made according to this approach is that there are no taxes involved in this and the use of debt doesn't change the risk factor for the investors and will remain the same throughout.

Operating leverage works on fixed cost as well as variable costs. It analyzes both of the costs and it remains in the company which has the highest proportion of fixed operating cost in relation to variable operating costs. The company uses fixed assets in operation of the company or vice versa. The company which is dealing in high operating leverage makes more money from additional sales if the company's cost doesn’t increase to produce more sales. For example the software developing company's cost structure remains fixed and limited to the development and marketing cost. It doesn't matter how many components they sell the cost remain fixed. It helps the investor in dealing with the information on the risk analysis of the company. High operating leverage sometimes helps benefiting companies and sometimes remain vulnerable to sharp economic and business cycle swings.

How is it computed?

Operating leverage is highest in companies which got fixed operating cost in relation to variable operating cost. It tells investor about the companies position and the risk profile of the company. It is measured when a company has fixed costs that are regardless the sales volume. When company has fixed cost then the percentage change in profits due to changes in sales volume is greater than the percentage change in sales. The computation of this is known as degree of operating leverage (DOL) which gives the extent to which operating profits change as sales volume changes. It is given as:-

DOL (Degree of operating leverage) = %age change in income / %age change in sale

Different types of leverage computed for financial analysis and they are as follows:-

1) Operating Leverage : - it is a leverage which refers to the enhancement of profits because there is a fixed operating cost which is involved with each and every component. When the sales increases fixed cost doesn't increase and it results in higher profits. Higher fixed expenses results in higher operating leverage which leads to higher business risk.

2.) Financial Leverage : - It is a leverage which refers to high level of profitability because of high fixed financial expenses. It includes interest on loan and preference dividend. Higher financial leverage indicates higher financial risk as well as higher break points. In this kind the managers have flexibility in choice of capital structure.

3.) Combined Leverage: - it is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas cooperative firms choose lower level of degree of combined leverage.

Leverage is a general term which is used in financial management and it is used as a technique to multiply the gains and losses. It refers of attainment of more benefits on comparative lower level of investment or lower sales. There are many ways to attain leverage the most common of them all is borrowing money, buying the fixed assets and use of derivatives. Examples of these are as follows:-

1) Public corporation may leverage its equity by borrowing money. The more a company borrows less equity capital it needs so the profits and losses are shared among small group of people.

2) Business Corporation may leverage its revenue by buying fixed assets. This will get more fixed proportion to the company rather than variable cost as change in revenue will result in larger change in operating income.

Price earnings ratio (P/E Ratio) is the ratio which is between the market price per equity and earning per share. High Price Ratio is used to give suggestion to the investors about their higher earning expected growth in future. It is usually used to compare the two P/E Ratio of different companies which are from the same industry. Investors should carefully note problems that arises with P/E Ratio measure to avoid biasing decision on many company's measure.

How is it calculated?

The P/E Ratio is calculated by dividing Market price per equity share to Earnings per share. This allows the company to estimate the appreciation in value of share of company and is used by investors for decision making on whether or not to buy shares in a particular company.

Following formula is used to calculate price earnings ratio:

“[Price Earnings Ratio = Market price per equity share / Earnings per share]”

For example:

The market price of share is Rs. 30 and earning per share is Rs. 5

Price Earning Ratio = 30/5 = Rs. 6

This shows that market value of every one Rs. of earning is Rs. 6. It is useful in calculation of financial forecasting and also helps in knowing whether or not the share of company are under or over valued.

What is its significance?

The significance of Price earning Ratio is it helps investor in deciding whether or not to buy the shares of particular company at a particular market price. Higher the P/E better is it for the company. If P/E ratio is low then the management should be more particular in knowing the cause of the fall as it can affect the company's position in the market.

Earning per share (EPS) is the amount of earning per each share of a company's stock. Companies require the EPS for their each income statement which shows about the continuing operations, discontinued operations, net income and outstanding items. EPS doesn't depend on the increase or decrease of the earning power of the company and gets calculated over number of years.

How is it calculated?

Earnings per share ratio (EPS Ratio) is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares. It is a small variance of return on equity capital ratio. The formula of Earning per share ratio is given as:-

“[Earnings per share (EPS) Ratio = (Net profit after tax - Preference dividend) / No. of equity shares (common shares)]”

What is its significance?

Earnings per share is a measure of profitability and it is viewed as the comparative earnings or the earning power of the respected firms. It is used from last four quarters but it can also be used to estimates the expected earnings of the next quarters as well.