The two broad sources of finance available to a firm are: shareholders’ funds and loan funds. Shareholders funds come mainly in the form of equity capital and retained earnings and secondary in the form of preferences capital. Loan funds come in variety of ways like debenture capital, term loans, deferred credit, fixed deposit, and working capital advance. Ignoring preference capital (which is of minor significance) the basic differences between shareholders’ funds (referred to as equity) and loan funds (referred to as debt) are as follows:
* Equity shareholders have a residual claim on the income and wealth of the firm.
* Dividend paid to equity shareholders is not a tax deductible payment.
* Lenders have a fed claim in the form of interest and principal payment.
* Interest paid to lenders is a tax deductible payment.
What are the key considerations in determining the debt equity ratio (the capital structure) of the firm? The important considerations in planning the capital structure are:
1. Earnings per share
5. Nature of assts
Earnings per share:
Earnings per share, which is simply equity earnings divided by the number of outstanding equity shares, is regarded as an important financial number that firms would like to prove. Hence we need to understand how sensitive is earnings per share (EPS) it changes in profit before interest and tax (PIT) under different financing alternatives.
To illustrate the relationship between PBIT and EPS under alternative financing plans, let us consider the following data for Falcon Limited.
Existing capital structure
10 million equity shares, par value Rs 10 each
Falcon Limited plans to raise additional capital of Rs 100 million of financing an expansion project. In this context, it is evaluating two alternatives financing plans: (1) issue of equity shares (10 million equity shares of Rs 10 per share). And (2) issue of debentures carrying 14 per cent interest.
What will be the EPS under the two alternative financing plans for two levels for PBIT, say Rs 20 million and Rs 40 million?
In general, the relationship between profit interest and taxes earnings per share is as follows:
Earnings per share
= [PBIT – Interest] (1—Tax rate) – preferences dividend /Number of equity shares
The break even PBIT for the two alternative financing plans is the level of PBIT at which EPS is the same under both the financing plans. It can be graphically obtained by plotting the relationship between PBIT and EPS under the two alternatives and noting to point of intersection. If PBIT is below Rs 28 million equity, financing is preferable to debenture financing, if PBIT is higher than Rs 28 million the opposite holds.
Risk: the two principal sources of risk in form are business risk and financial risk. Business risk refers to the variability of profit before interest and taxes. It is influenced, interalia, by the following factors:
1. Demand Variability: Other things being equal, the higher the variability of demand for the products manufactured by the firm, the higher is its business risk.
2. Price Variability: A firm which is exposed to a higher degree of volatility for the process of its products is, general, characterized by a higher degree of business risk in comparison with similar firms which are exposed to a lesser volatility for the process of their products.
3. Variability of input Prices: When input prices are highly variable, business risk tends to be high.
4. Proportion of Fixed Costs: If fixed costs represent a substantial proportion of total costs, other being, business risk is likely to be high. This is because when fixed costs are high, PBIT is more sensitive to variations in demand.