Capital Structure

Cost of equity share is the part of cost of capital which allows the payment to only the equity shareholders. In this every shareholders get the shares for getting the return on the shares on which they are investing so much. From company's perspective the company must earn more than cost of equity capital in order to be unaffected by the market value of the shares of its.

To measure the cost of equity shares we have to follow the following ways:-

1) Dividend yield method or Price ratio method

In this the minimum rate of cost of equity shares will be equal to the “present value of future dividend per share with current price of a share”.

Cost of equity shares= Dividend per equity/ Market price

For example if there is a company which issues shares of Rs. 200 each a premium of 10%. The company pays 20% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it be different if market price of equity share is Rs. 260?

The solution can be found out by our formula which says

Cost of equity shares= Dividend per equity/ Market price

= 20*100/210

= 9.52%

If the market price of equity share is Rs. 260.

=20* 100/260 = 7.69%

Composite cost of capital is also known as weighted average cost of capital which is a measurable unit for it. It also tells about the component costs of common stock, preferred stock, and debt. Each of these components is given weightage on the basis of the associated interest rate and other gains and losses with it. It shows the cost of each additional capital as against the average cost of total capital raised. The process to compute this is first computing the weighted average cost of capital which is the collection of weights of other costs summed together. The formula is given as:-

WACC= Wd (cost of debt) + Ws (cost of stock/RE) + Wp (cost of pf. Stock)

In this the cost of debt is calculated in the beginning and it is used to find out the cost of capital and other weights of cost is been calculated after the calculation each and every individual weight of the component is added and then it gives the final composite cost..

Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is used in financial investment which refers to the cost of a company's funds or the shareholders return on the company's existing deals. It is the required rate that a company must achieve to cover the cost of generating funds in the market. By seeing this only the investor invests the money in the company if the company is giving the required rate of return. It is a guideline to measure the profitability of different investments.

The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. It actually used in managerial decision making in certain field such as-

1) Decision on capital budgeting- It is used to measure the investment proposal to choose a project which satisfies return on investment.

2) Used in designing corporate financial structure- it is used to design the market fluctuations and try to achieve the economical capital structure for firm.

3) Top management performance- It evaluates the financial performance of top executives. It involves the comparison of actual profit of the projects and taken projects overall cost.

The component cost is the one which comes under the cost of capital and it has three levels:-

(i) Return at zero risk level: which tells about the expected rate of return when there is no risk involved in the project

(ii) Premium for business risk: This tells about the variance in operating profit due to change in sales.

(iii) Premium for financial risk: This tells about the captital structure risk.

It is the decision whether to buy components or services from an outsider or not. It requires understanding the cost associated with building and buying the components.

Composite Capital is also called the weighted average of component cost of common stock, preference shares and debt. In this each of the components is given an importance on its interest rate, risk analysis and management loss of control which is used to compute the composite capital.

The general factors which are affecting the capital structure are as follows:-

1) Company constitution : In companies capital structure is very important as many companies treat it as a different entity. Private companies considers control factor as important whereas public company finds cost factor more important.

2) Company characteristics : Characteristic of the company which describe its infrastructure as size, age and credit plays pivotal role in deciding the capital structure. Smaller or newly started companies depend more on equity capital as they can do limited bargaining. Large companies or having good credit companies are in the position to get funds from the source of their choice.

3) Stability of Earnings : Fluctuations occurs if the sales and earnings of the company are not stable enough over a period of time. Stable company can take the risk.

4) Attitude of the Management: Attitude plays an important role as if the attitude is conservative then control factor gets the importance and if it is liberal then cost factor gets important.

The external factors which are affecting the capital structure are as follows:-

1) Economic Conditions: If the economy is in state of depression, preference is given to equity form of capital which involves less amount of risk but it is avoided in some cases where the investor is not ready to take the risk. In this case company go on with the borrowed capital.

2) Interest Rates level : Form of borrowed capital will be delayed if the funds are available in high rates of interest but raising is not favourable.

3) Lending Policy : If policy is hard to understand and not flexible then it is good to go with the borrowed capital.

4) Taxation Policy: This policy should be viewed from both the sides from individual as well as corporate perspective. From the individual point of view both interest as well as dividend will be taxable in hands of lender.

The internal factors which are affecting capital structure are as follows:-

1) Cost of capital : - it is a process of raising the funds which involves the cost in planning the capital structure, the use of capital should be capable of earning revenue to meet the cost of capital. There are changes in this because of two reasons:

(i) Interest rates are less than dividend rates.

(ii) Interest paid on borrowed capital is an allowable for income tax purposes.

2) Risk factor : Company raising the capital by borrowed capital, as it accepts the risk in two ways:

(i) Company maintains the payment of interest as well as installments of borrowed capital at predecided rate and time without being concerned about the profits and losses.

(ii) Borrowed capital is secured capital in the case where the company fails to meet the contract done with the lenders of the money.

3) Control Factor: These factors have been considered by the private companies while raising additional funds and planning the capital structure. In this company plans to raise long term funds by issue the equity and preference shares. It doesn't have relation with the borrowed capital.