UNIT-3

FINANCING DECISION
INTRODUCTION

INTRODUCTION

A firm can make use of different sources of financing whose costs are different, that
is, funds which carry a fixed rate of return, (debentures and preference shares) and
those with variable returns (equity shares). The fixed returns on some sources of
finance, have implications for those who are entitled to a variable return. The term
capital structure refers, to the composition of the long-term sources of funds, with
an optimum debt and equity mix, where the cost of capital is minimum and the
market price per share is maximum.
Meaning of Capitalization
Capitalization means estimation of how much fund required to run the business.
Selection sources of funds proportion in which different kinds of securities to be
issued and administration of fund
Definition of Capitalization
• According to Gerstenberg “Capitalization comprises ownership capital which
includes capital stock and surplus in whatever form it may appear and
borrowed capital which consists of bonds or similar evidence of long-term
debt”
• Guthman and dougall defines “Capitalisation is the sum of the par value of
stocks and Bonds outstanding”

Meaning of Finance structure

• Financial structure refers to the method by which the Firms assets are
Financed.
 • In other words, financial structure includes both long term and short-term
sources of funds.
Definition of Finance structure
• Capital structure means the total combined investment of a business
consisting of equity share capital, debentures, retained earnings, preference
shares and other long term borrowed funds
• Capital structure includes all the long-term capital resources including loans,
shares issued, reserves etc.
Definitions of Capital Structure
• Robert H wissels defines “The term capital structure is frequently used to
indicate the long-term sources employed in a business enterprise”
• John Hampton defines “Capital structure refers to the composition of debt and
equity securities that comprises a firm financing of its assets”

FACTORS AFFECTING OR INFLUENCING ON CAPITAL STRUCTURE

• Financial Risk –Risk of cash insolvency because of an uncertainty in future cash flows. Risk
of variation in expected earnings to shareholders. Earnings to shareholders will increase if the
return on investment is higher than the cost of debt and vice versa.

• Cost of capital - cost of a source is the minimum return expected by its

suppliers which depends on the degree of risk (risk return). Theoretically the
optimal debt equity mix for the company is at a point where the overall cost
of capital is minimum.
• Cash flow ability to service debt – Servicing of debts does not merely depend
on the sufficient profits, but availability of cash. It is necessary to estimate
cash flows before deciding on the proportion of debt. The analysis brings
together the business and financial risk of a company. It allows to address the
likelihood of insolvency and the cost therein.
• Control – Balancing between dilution of control because of more equity and
financial risk arising out of variation in expected future earnings in the use of
debt.
• Size of Company – often smaller companies have to depend on owner’s funds
because of reluctance of lenders in providing long term debt.
 • Taxes – The degree to which a company is subject to taxation is very
important. Much of the advantage of debt is tax related. If the company pays
little or no tax, debt is far less attractive than it is for the company subject to
the full corporate tax rate.
• Firms stage in the lifecycle:
◦ Start-ups – owner’s equity and bank debt.
◦ Expansion - investment needs will be high and will generally look for
private equity or venture capital or Issue of IPO.
◦ High Growth - firms will look for more equity issues. If using debt,
convertible debt is most likely to be used.
◦ Mature growth – the earnings and cash flows will continue to increase
reflecting the past investments. Need for investments in newprojects
will decline. Funding needs will be covered by internal accruals, debts
or bonds.
◦ Decline – existing investments will continue to yield cash flows but at a
lower pace. Firms unlikely to make fresh funding and are likely to retire
existing debt and buy back stocks.
• Flexibility – Ability to change the composition in future. Promoters often use
unsecured debt to achieve flexibility.
• Others: Market conditions, period of finance, industry (capital intensive).

Meaning of optimum capital structure

A firm should select such financing mix which maximizes its value/shareholders wealth
long term. Theoretically, it (optimum capital structure) is the capital structure at which the
weighted average cost of capital is minimum thereby maximizing value of the firm.
Capital structure refers to the amount of debt and/or equity employed by a firm to fund its
operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-
equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital expenditures,
acquisitions, and other investments. There are tradeoffs firms have to make when they decide
whether to use debt or equity to finance operations, and managers will balance the two to find
the optimal capital structure.

Meaning of Capital Gearing

The term capital gearing refers to the ratio of debt a company has relative to equities.
Capital gearing represents the financial risk of a company. It is also referred to as financial
gearing or financial leverage. A company is said to have a high capital gearing if the company
has a large debt as compared to its equity.

It tells us about companies’ capital structure. Broadly, Capital Gearing is nothing but the
ratio of Equity to Total Debt. This critical information about capital structure makes this ratio
as one of the most significant ratios to look at before investing.

Through this ratio, investors can understand how geared the capital of the firm is. The firm’s
capital can either be low geared or high geared. When a firm’s capital is composed of more
common stocks rather than other fixed interest or dividend-bearing funds, it’s said to have been
low geared. On the other hand, when the firm’s capital consists of less common stocks and
more of interest or dividend-bearing funds, it’s said to be highly geared.

LEVERAGES
Meaning:
 Leverage is an investment strategy of using borrowed money—specifically, the use of
various financial instruments or borrowed capital—to increase the potential return of an
investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
In financial analysis the term leverage means influence of one financial factor or variable
of one financial factor over some other related financial factor
Definition of leverages
• According to Solomon Ezra “leverage is the ratio of rate of return on shareholders’
equity and the rate of return on total capitalization”
• According to Charity and roden “Leverage is the tendency of the profit for change at a a
faster rate than sales”
Types of leverages
(i) Operating leverage
(ii) Financial leverage and
(iii) Combined leverage
(i) Operating leverage
Meaning: Operating leverage refers to the use of fixed operating costs such as
depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the
operations of a firm. But it does not include interest on debt capital. Higher the
proportion of fixed operating cost as compared to variable cost, higher is theoperating
leverage, and vice versa

Degree of Operating Leverage

The earnings before interest and taxes (i.e., EBIT) changes with increase or decrease
in the sales volume. Operating leverage is used to measure the effect of variation in
sales volume on the level of EBIT.

(ii) Financial leverage

Meaning: Financial leverage is primarily concerned with the financial activities
which involve raising of funds from the sources for which a firm has to bear fixed
charges such as interest expenses, loan fees etc. These sources include long-term debt
(i.e., debentures, bonds etc.) and preference share capital.

Degree of Financing Leverage:

Financing leverage is a measure of changes in operating profit or EBIT on the levels
of earning per share.
(iii) Combined leverage
Combined leverage 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.

Degree of Combined Leverage (DCL)

Degree of Combined Leverage (DCL) is the leverage ratio that sums up the combined
effect of the Degree of Operating Leverage (DOL) and the Degree of Financial
Leverage (DFL) has on the Earning per share or EPS given a particular change in
shares. This ratio helps in ascertaining the best possible financial and operational
leverage that is to be used in any firm or business.

Formulae of leverages

Formula of degree of operating leverages

Formula of degree of financial leverages

Formula of degree of Combined leverages

EBIT and EPS analysis

Meaning of EBIT: Earnings before interest and taxes (EBIT) is an indicator of a

company's profitability. EBIT can be calculated as revenue minus expenses excluding tax
and interest. EBIT is also referred to as operating earnings, operating profit, and profit before
interest and taxes.
Format for calculation of EBIT,EBT,EAT,EAESH

Particulars Amount

Sales

Less: Variable Cost

Contribution

Less: Fixed Cost

EBIT (Earnings Before Interest and Tax)

Less: Interest

EBT (Earning Before Tax)

Less: Tax

EAT (Earning After Tax)

Less: PD (Preference Dividend)

EAESH (Earning/Profit available to Equity Shareholders)

Formula and Calculation for EBIT
EBIT = Revenue − COGS − Operating Expenses
Or
EBIT = Net Income + Interest + Taxes
Whereas: COGS = Cost of goods sold

Meaning of EPS:
Earnings per share (EPS) is calculated as a company's profit divided by the outstanding
shares of its common stock. The resulting number serves as an indicator of a company's
profitability. It is common for a company to report EPS that is adjusted for extraordinary items
and potential share dilution. The higher a company's EPS, the more profitable it is considered
to be.
Formula and Calculation for EPS
Earnings per Share=
Net Income − Preferred Dividends/End-of-Period Common Shares Outstanding