An understanding of capital leverage and stock trading
“After severe financial crises in the economy, for a corporate entity, it is very important to have a perfect mix of various sources of capital to ensure good returns and overcome deep losses.”
Here, some crucial terms have been defined with reference to the financial system of a company:
CAPITAL STRUCTURE
The types of securities to be issued and the proportional amounts that make up the capitalization are known as the capital structure or financial structure.
Capital structure refers to the ratio of different types of securities issued by a company to obtain long-term financing. Thus, the capital structure denotes: (1) the types of securities issued (capital shares, preferred shares, and debentures), and (ii) the relative proportion of each type of security. In other words, the capital structure represents the proportion of share capital and departmental capital that is used to finance a company’s operations. An appropriate balance must be obtained in the following values or sources of financing to maximize the wealth of the shareholders of the company:
(in equal parts,
(b) preference shares, and
(c) obligations
Characteristics of a solid capital structure
A company’s capital structure is said to be optimal when the ratio of debt to equity is such that it maximizes shareholder return. Such a structure would vary from company to company depending on the nature and size of the operations, the availability of funds from different sources, the efficiency of management, etc.
A SOLID CAPITAL STRUCTURE SHOULD HAVE THE FOLLOWING CHARACTERISTICS:
(i) MAXIMUM RETURNS.
(ii) LESS RISKY.
(iii) FLEXIBILITY
(iv) ECONOMY.
(v) DYNAMIC.
FINANCIAL LEVERAGE OR CAPITAL GEAR
A company can raise capital by issuing three types of securities: (a) equity shares, (b) preferred shares, and (c) debentures. Preference shares have a fixed dividend rate and debentures have a fixed interest rate. Equity shares are paid dividends from the earnings that remain after interest payments on the debentures and dividends on the preferred shares. Therefore, the dividend of equity shares may vary from year to year. Equity shares are known as equities and debentures and preferred shares as fixed income securities. If the rate of return on fixed income securities is less than the company’s rate of profit, the return on equity shares will be higher. This phenomenon is known as financial leverage or capital leverage.
Thus, financial leverage is an arrangement whereby fixed-yield securities (bonds and preferred stock) are used to raise cheaper funds to increase shareholder returns. It may be noted that a lever is used to lift something heavy by applying less force than would otherwise be required.
Capital leverage denotes the relationship between various types of securities and total capitalization. A company’s capitalization is highly oriented when the ratio of equity capital to total capitalization is small, and low oriented when equity capital dominates the capital structure.
Equity leverage is calculated by determining the ratio of the amount of equity capital (representing equity-bearing securities) to the total amount of securities (equity shares, preferred shares, and debentures) issued by a company. Here is the capital structure of two different companies. Both companies have issued total securities worth Rs 20,00,000 and have equity shares worth Rs 5,00,000 and Rs 15,00,000 respectively. Company A is highly oriented as the ratio of share capital to total capitalization is small, ie 25%. But in the case of company B, this proportion is 75%, so it has low indebtedness.
CAPITAL GEAR ANALYSIS
Company
(RS.)
(a) Capital stock in shares 5,00,000
(b) Obligations 15,00,000
(c) Total Capitalization 20,00,000
(d) Capital Gearing (a/c × 100) = 5,00,000/ 2,00,000 × 100
= 25% (High Gear)
The various securities issued must have such a relationship to the total capitalization that the capital structure is safe and economical.
Equity shares should be issued when there is uncertainty about earnings. Preferred shares, particularly cumulative shares, should be issued when average earnings are expected to be quite good. Debentures should be issued when the company expects substantially higher future earnings to pay interest to debenture holders and increase shareholder returns.
NEGOTIATION OF SHARES
Stock trading is an arrangement under which financial management raises funds by issuing securities that carry a fixed rate of interest (or dividend) that is less than the company’s average earnings. This is done to increase the return on equity shares.
Suppose a company requires an investment of Rs 10 lakhs to earn Rs 2.5 lakhs at 25 per cent per annum To increase this amount, we can consider two proposals viz (A) issue 1 lakhs capital shares out of 10 rupees each: and (B) issue equity shares worth Rs 2.5 lakhs (ie 25,000 shares worth Rs 10 each), 8% preference shares worth Rs 2.5 lakhs and 10% bonds worth Rs 5 lakhs. The tax rate is assumed to be 40 percent. Earnings per share under proposal ‘B’ will be higher due to the application of ‘share trading’. As shown in the table below, the earnings per share (EPS) under proposal B is Rs 4.00 compared to Rs 1.50 under proposal A due to the use of debentures and preferred capital to raise funds.
EFFECT OF NEGOTIATION ON EQUITY
- Special Proposals
- Earnings Before Interest and Taxes (EBIT) Rs 250,000
- Less interest on obligations (10%) Zero
- Profit after interest and before taxes 2,50,000
- Less Tax (40%) 1,00,000
- Profit after interest and taxes 1,50,000
- Less Preferred Dividend (8%) Zero
- Earnings Available to Equity Shareholders 1,50,000
- No. of outstanding capital shares 1,00,000
- Earnings Per Share (EPS) Rs 1.50