Financial Management; Capital Structure Short Answer Questions 1. What is a capital structure? It is the determination of ratio of capital to be raised from different sources. The capital structure decision involves the proportion of equity and debt. 2. What is optimal capital structure? It is the combination of debt and equity that leads to the maximization of the value of the firm, 3. What is capital expenditure/budget? A capital expenditure budget is a formal plan that states the amounts and timing of fixed asset purchases by an organization. This budget is part of the annual budget used by a firm, which is used to organize activities for the upcoming year. 4. What is EPS? Earnings per share (EPS) is the portion of a company’s profit allocated to each share of common stock. Earnings per share serve as an indicator of a company's profitability. 5. Expand EAT, EBIT and PAT. + Earnings after tax (EAT) - it is a term that refers to financial result for an accounting period. It is already after taxation and it is available for distribution between the owners and the company. + Earnings before interest and tax (EBIT) - is a measure of a firm’s profit that includes all incomes and expenses except interest expenses and income tax expenses + Profit after tax (PAT) which depends upon interest and the tax 6. Give the meaning of P/E ratio. ‘The price-to-earnings ratio (P/E ratio) - is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple. ‘+ Used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. ‘+ Used to compare a company against its own historical record or to compare aggregate markets against one another or over time. + Formula: P/E Ratio=Earnings per share / Market value per share Extended Answer Questions 1. Explain the features of capital structure. + Itallows maximum possible use of leverage. + It involves minimum possible risk of loss of control. It helps to avoid undue restrictions in agreement of debt. Ithelps avoid undue financial risk with the increase of debt. It takes care that the use of debt is within the capacity of a firm. ‘The firm should be in a position to meet its obligations in paying the loan and interest charges as and when they fall due. 2. Discuss the major considerations in capital structure planning. + Risk of insolvency or cash payment capacity - EBIT is not enough to pay the interest. Interest in paid only out of cash earned profit ‘This documents avalabe toe of chargeon SEUDOCU.COM Downloaded by Mohanaprasath C (mohanaprasath.c@gmall.com)Risk of variation in the earning - Risk of variation in the expected earning to the equity share holders Cost of borrowed capital - Amount of interest paid to the debenture holders. Analysis of balance sheet - It establish the relationship between Current Assets to Current Liabilities and Fixed Assets to Fixed Liabilities. Division of Current Assets - It is divided into two categories i.e, Variable Current Assets (stock, debtor) which vary with the operation of the business, Permanent Current Assets (cash, bank balance) which have a minimum limit and below which it should be with the business Period of finance - Long term or short term is the basic aim of investment planning Le, uses of fund in the resources of the business on the basis of fixed or current. Distribution of profit - EBIT is the claim of three parties that means debt holders, govt, and shareholder. 3. Explain the value of the firm and capital structure. A firm mobilizes funds which, depending upon their maturity period, can be classified as Iong-term and short-term sources. The former consists of capital, reserves and term loans raised from public and financial institutions, while the latter is made up of current abilities and provisions. Financing decisions involve raising funds for the firms. It is concerned with formulation and designing of capital structure or leverage. 4. Briefly explain the capital structure theories. ‘Though there are many theories advocated by the noted economists, the two different views have been drawn regarding capital structure of the firm. One view states that the value of the firm depends on the capital structure in-turn it emphasises on the cost of capital. It advocates that optimal capital structure of the firm at which the overall cost of capital (Ko) will be minimum and thereby the value of the firm increases. The second view point states that the optimal capital structure will not have any bearing on the value of the firm and the market value of the firm remains same for any combinations of capital ratio. Thus the capital structure of the firm is irrelevant with regard to the value of the firm, 5. Explain the factors influencing capital structure. Internal factors, Size and Nature of Business: This has great impact on its capital structure. Trading concerns raise capital by issue of equity as well as preference shares as they require more working capital, Small companies have limited capacity to raise funds from external sources. Large companies possess huge investments Capital Gearing: The ratio between debt capital and equity capital is called capital gearing. It is high gearing when the proportion of debt capital is high than the equity share capital while it is low gearing when the proportion of debt capital is low than the equity share capital. Requirement of Capital: In the initial stages of business, a company cannot issue varieties of securities as. there is considerable risk involved and hence, it is preferable to raise capital through equity shares. Adequate Earnings and Cash Position: Companies with unstable earnings should not opt for debt in their capital structure as they may face difficulty in paying the fixed amount of interest. Future Plans and Development: Capital structure is designed by the management keeping in mind the future development and expansion plans Downloaded by Mohanaprasath C (mohanaprasath.c@gmall.com)+ Period of Finance: While framing capital structure, the ‘period for which finance is needed’ must also be considered. + Trading on Equity: The use of borrowed capital for financing a firm is known as ‘Trading on Equity. Trading on equity is double edged sword. It may increase the income of the shareholder if things head in a proper direction, On the other hand, it increases the risk of loss under unfavourable conditions. + Attitude of Management: Capital structure is influenced by the attitude of the persons in the management, If the management wishes to have exclusive control, they raise capital through preference shares and debt capital, + Growth of Business Firm: Capital requirement of a firm depends upon the stage of development, At the initial stage, the source of finance is mostly equity shares and short term loans. As the stage progresses, the requirement increases and funds are procured by issuing debentures and preference shares. External Factors: + Market Conditions: Various methods of financing should be considered depending upon the prevailing market conditions. If the share market is in a declining situation, the company should raise funds by issuing debts. + Attitude of Investors: If the investors prefer to take risk and expect higher returns, they invest in equity shares. If the investors prefer to earn safe and assured income and are not ready to take risk, they invest in preference shares and/or debentures. + Government Rules and Regulations: According to SEBI, the normal debt equity ratio is 2: 1, However, in case of large capital intensive projects, the permitted ratio is 3 1. Government provides aid and concessions to small industrial projects to raise more debt capital. + Rate of Interest: Capital structure depends upon the rate of interest prevailing in the market. If the rate of interest is higher, firms delay debt financing, Conversely, if the rate of interest is lower, firms will opt for debt financing. + Competition: The company which faces cut-throat competition should raise funds by issuing equity shares as their earnings are not certain and adequate. + Cost of Capital: Cost of capital is the minimum return expected by its supplier /investor. The expected return depends upon the degree of risk. However, the company cannot minimize cost of capital by employing only debt. As debt becomes more expensive beyond a particular point due to the increased risk of excessive debt. + Attitude of Financial Institutions: If financial institutions prescribe high terms of lending. then the company should move to other source of financing, However, if financial institutions prescribe easy terms of lending, the company should obtain funds from such institutions. + Taxation: Interest paid against debt is tax deductable expenditure whereas dividend 1s not considered as tax deductable expenditure for the company. 6. Briefly explain EBIT-EPS analysis EBIT-EPS analysis is a technique used to determine the optimal capital structure in which the value of earnings per share (EPS) has the highest amount for a given amount of earnings before interest and taxes (EBIT). Its objective is to determine the effect of using different sources of financing on EPS, Formula: EBIT-EPS analysis = (EBIT ~ 1) (1-1) ~ PD, / Sy = (EBIT~ 15) (1-1) ~ PDs / Sa Advantages + Financial planning: it allows earnings per share to be maximized for any given value of earnings before interest and taxes. It helps to choose the best financing plan, + Comparative analysis - such analysis is possible not only for a company as a whole but also for a specific product, project, department, or market ‘This documents avalabe toe of chargeon SEUDOCU.COM Downloaded by Mohanaprasath C (mohanaprasath.c@gmall.com)+ Determination of target capital structure - management of a company is able to determine the target capital structure for maximizing EPS. Disadvantages + Risk is not taken into account - does not take into account the risks associated with debt financing, + Complexity the more alternative financing plans are considered, the higher the complexity of the calculations. ‘+ Limitations - the technique does not account for limitations in raising various. sources of financing 7. Discuss the effects of a financing decision on earnings per share. ‘+ Adjusting for the Political Risk - Risk premium to be incorporated in the in the cost of capital for a project in a country with high political risk will have to be higher than in case of country with lower political risk. + Adjusting for Segmentation of Capital Markets - Cost of capital for a project in a segmented host country capital markets has to be adjusted downward because restrictions are clamped on capital outflow, resulting in availability of funds in the host country ‘+ Multinational Financial Management Companies. Many of them are not fully aware of MNCs’ shares in their country’s market. + Adjusting for the International Diversification Effect- The beneficial impact of international diversification is reflected in reduced exchange rate and country risks. + Determining cut-off rate for foreign projects appraisal - Cut-off rate is the minimum rate of return that must be earned on a foreign project if the firm's value has to be maintained. Determining the cut-off rate 1s, therefore, imperative for assessing viability of a foreign project. + Adjusting for the Exchange Risk - The cost of capital of a foreign project may be adjusted by the average rate of appreciation (depreciation) of the host country's currency during the life of the project. 8. Write short note on EPS volatility. Earnings per share (EPS) is the portion of a company’s profit allocated to each share of, common stock. Volatility is a measure of how much the value of a variable fluctuates. To measure volatility, statisticians calculate variance and standard deviation. ‘+ Earnings volatility refers to how stable, or unstable, the earnings of a corporation + Stock Price Volatility- Since stocks trade and are priced on every business day, a lot more stock price data accumulates than earnings data. * Good Volatility - Not all earnings volatility is bad. Similarly, not all stability is good. ‘Therefore, as with every other financial measure, volatility must be evaluated within the right context. Downloaded by Mohanaprasath C (mohanaprasath.c@gmall.com)