EBIT I VD
2,00,000 56,000 20,00,000 8,00,000 100
1,44,000 12,00,000 100 = 12%
where I = Interest of debt V = Value of the firm D = Value of debt capital I =
8,00,0007%=56,000 V = 20,00,000 D = 8,00,000
(b) If the debenture d
defined as the capital structure or combination of debt and equity, that leads to
the maximum value of the firm.
Objectives of Capital Structure Decision of capital structure aims at the following
two important objectives: 1. Maximize the value of the fir
composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital. It is used to understand the total cost
associated with the total finance of the firm.
IMPORTANCE OF COST OF CAPITAL Computat
up to Rs. 3,00,000 at 8% over Rs. 3,00,000 to Rs. 15,000,00 at 10% over Rs.
15,00,000 at 15% Assuming a tax rate of 50% advise the company. Solution
Earnings Before Interest and Tax (BIT) less Interest Earnings Before Tax less:
Alternatives I II
curve upward (if the seller pays the tax) or moving the demand curve downward
(if the buyer pays the tax). SeeFigure 8.1 "Change in Market Equilibrium in
Response to Imposing an Externality Tax" for a graphic illustration of a tax
Saylor URL: http:/www.sa
Risk Due Debt Risk Bearing Debt
Fig. 5.2 Modigliani and Miller Approach
Exercise 6 There are two firms A and B which are exactly identical except that A
does not use any debt in its financing, while B has Rs. 2,50,000 , 6% Debentu
the use of fixed cost funds. Favourable financial leverage occurs when the
company earns more on the assets purchased with the funds, then the fixed cost
of their use. Hence, it is also called as positive financial leverage. Unfavourable
shares =10 lakhs Market value of existing share =Rs.100 Net earnings =Rs.100
lakhs Compute the cost of existing equity share capital and of new equity capital
assuming that new shares will be issued at a price of Rs. 92 per share and the
costs of new issu
According to the definition of R.H. Wessel, The long term sources of fund
employed in a business enterprise.
FINANCIAL STRUCTURE The term financial structure is different from the capital
structure. Financial structure shows the pattern total financing. I
Value of no. per share =
Sources of Financing
CREDITORSHIP SECURITIES Creditorship Securities also known as debt finance
which means the finance is mobilized from the creditors. Debenture and Bonds are
the two major par
of preference shares. It is called as fixed income security because it provides a
constant rate of income to the investors.
2. Cumulative dividends: Preference shares have another advantage which is
called cumulative dividends. If
operating income approach. If the debentures debt is increased to Rs. 10,00,000.
What will be the effect on volume of the firm and the equity capitalization rate?
Solution Net operating income = Rs. 2,00,000 Overall cost of capital = 10% Market
value of t
Computation of Leverage
Plan 1 2 Situation i ii i ii Sales 60,000 60,000 60,000 60,000 Less : Variable
cost 36,000 36,000 36,000 36,000 Contribution 24,000 24,000 24,000 24,000 Less :
Fixed cost 5,000 10,000 5,000 10,000 Operating
many problems in the field of financial management. Because there is a confusion
among the capital, capitalization and capital structure.
Meaning of Capitalization Capitalization refers to the process of determining the
quantum of funds that a firm needs
12. Firm pays tax at 60%. Compute the after tax cost of capital of a preferred share
sold at Rs. 100 with a 8%. Dividend and a redemption price of Rs.110, if the
company redeems in five years. (Ans. 9.52%) 13. Your company share is quoted in
the above benefits. They are eligible to get only dividend if the company earns
profit during the years. Otherwise, they cannot claim any dividend.
Sources of Financing
3. Redeemable preference shares: When, the preference shares have a fixed
COMBINED LEVERAGE When the company uses both financial and operating
leverage to magnification of any change in sales into a larger relative changes in
earning per share. Combined leverage is also called as composite leverage or total
leverage. Combined l
Definition of Leverage James Horne has defined leverage as, the employment of
an asset or fund for which the firm pays a fixed cost or fixed return.
Types of Leverage Leverage can be classified into three major headings according
to the nature of the fina
company. When the company is going to invest large amount of finance into the
business, it is called as capital. Capital is the initial and integral part of new and
existing business concern. The capital requirements of the business concern may
Plan I Plan II Plan III Equity capital Rs. 2,000 Rs. 1,000 Rs. 3,000 Debt Rs. 2,000 Rs.
3,000 Rs. 1,000 EBIT Rs.
400 Interest @10% per annum on
debts in all cases.
Plan I Plan II Plan III Rs. Rs. Rs. EBIT 400 400 400 Less Interest
crucial part of the business concern, because these decisions are directly related
with the value of the business concern and shareholders wealth. Like financing
decision and investment decision, dividend decision is also a major part of the
get fixed rate of interest at every end of the accounting period. Debenture holders
have priority of claim in income of the company over equity and preference
shareholders. 3. Residual claims on asset: Debenture holders have priority of
claims on Assets o
Comments From the above data, if debt of Rs. 2,50,000 is used, the value of the
firm increases and the overall cost of capital decreases. But, if more debt is used to
finance in place of equity i.e., Rs. 4,00,000 debentures, the value of the firm
Combined leverage = 2 1.25 = 2.5 Exercise 5 Calculate the operating, financial
and combined leverage under situations 1 and 2 and the financial plans for X and
Y respectively from the following information relating to the operating and capital
multidimensional activities. Development banks are also called as financial
institutions or statutory financial institutions or statutory non-banking institutions.
Development banks provide two important types of finance: (a) Direct Finance (b)
Advantages of Retained Earnings Retained earnings consist of the following
important advantages: 1. Useful for expansion and diversification: Retained
earnings are most useful to expansion and diversification of the business activities.
2. Economical sour
less than its book value. According to Hoaglands definition, A stock is said to be
watered when its true value is less than its book value.
Causes of Watered Capital Generally watered capital arises at the time of
incorporation of a company but it also ar
Market value of equity = 8,00,000 Market value of debentures = 2,50,000 Value of
the firm = 10,50,000 Calculation of overall capitalization rate
Overall cost of capital (Ko)=
1,00,000 10,50,000 100 = 9.52% (b) Calculation
7,60,000 6,00,000 9,40,000
Exercise 9 The following is the data regarding two Companys. X and Y
belonging to the same risk class.
XY No. of ordinary shares 90,000 1,50,000 Market price/share (Rs.) 1.2 1.0 6%
debentures 60,000 Profi