"After severe economic downturns, it is crucial for a business entity to maintain a correct balance of different capital sources to ensure strong returns and recover from the depth of losses,"
Here, key terminology that pertains to a company's financial system has been defined:
PUBLIC STRUCTURE
The capital structure, also known as the financial structure, consists of the different securities that will be issued and the proportionate quantities that make up the capitalization.
The proportion of various types of securities that a firm issue in order to raise long-term financing is referred to as capital structure. As a result, capital structure indicates I the proportional proportion of each type of security; and (ii) the categories of securities issued (equity shares, preference shares, and debentures). In other words, the capital structure reflects the ratio of debt and equity capital utilized to fund a company's activities. To maximize the wealth of the company's equity owners, a proper balance must be attained in the following securities or sources of funding:
(a) Shares of equality,
(b) preferred stock, and
Debentures (c)
Sound capital structure characteristics
When the ratio of debt to equity is such that it maximizes the return for equity shareholders, such capital structure is said to be optimal for the company. Depending on the type and scale of activities, the availability of funding from various sources, the effectiveness of management, etc., such a structure would differ from firm to company.
A GOOD CAPITAL STRUCTURE SHOULD HAVE THE FEATURES LISTED BELOW:
I HAVE THE HIGHEST RETURNS.
Less risky is (ii).
Flexibility (iii)
IV) THE ECONOMY
dynamic (v).
LEVERAGE OR CAPITAL GEARING IN FINANCE
Three different types of securities, including equity shares, preference shares, and debentures, can be used by businesses to raise cash. Both the dividend and interest rates on preference shares and debentures are fixed. When interest on debentures and dividends on preference shares have been paid, any earnings are used to pay dividends on equity shares. Consequently, dividends on equity shares may change from year to year. Debentures and preference shares are classified as fixed return securities, whereas equity shares are known as variable return instruments. The return on equity shares will be higher if the rate of return on fixed return instruments is lower than the rate of earnings of the company. Capital gearing or financial leverage are terms used to describe this situation.
Financial leverage is a strategy where fixed return-bearing securities (such as preference shares and debentures) are utilized to obtain money at a lower cost in order to boost the return to equity stockholders. It should be noted that using a lever allows one to lift objects that would otherwise demand a lot of force with less effort.
The ratio of different forms of securities to total capitalization is known as capital gearing. When the share of equity in total capitalization is modest, a company's capitalization is high geared, and when equity capital dominates the capital structure, it is low geared.
The quantity of equity capital—representing securities yielding variable income—to the total number of securities—equity shares, preference shares, and debentures—issued by a company—is used to determine capital gearing. Presented here is the capital structure of two distinct businesses. Both firms have issued securities totaling Rs. 20,00,000 and have equity shares worth, respectively, Rs. 5,00,000 and Rs. 15,00,000. Due to the low, or 25%, equity capital to total capitalization ratio, Company A is heavily geared. However, firm B is low geared because this ratio is 75% in its case.
A CAPITAL GEARING ANALYSIS
Company
(Rs.)
5.000.000 in equity share capital
Debentures of 15,000,000.
(c) Total Investment $20,000
(d) Capital Gearing (a/c100)=5,000/2,000100
= 25% (High Gearing)
The various securities issued should have a secure and affordable capital structure in relation to the total capitalization.
Where there is a likelihood of earnings unpredictability, equity shares should be issued. When average earnings are anticipated to be rather excellent, preference shares, especially cumulative ones, should be issued. When a corporation anticipates reasonably higher earnings in the future, it should issue debentures in order to pay interest to holders and boost returns to stock investors.
Trading on stocks
Trading on equity is a strategy used by financial management to obtain money by issuing securities with fixed interest rates (or dividends) that are lower than the company's typical earnings. To boost the return on equity shares is done.
Let's say a business needs to invest Rs. 10 lakhs in order to generate Rs. 2.5 lakhs at a 25% annual return. In order to raise this money, we may take into consideration one of two proposals: (A) to issue 1 lakh equity shares worth Rs. 10 each; or (B) to issue 2.5 lakhs worth of equity shares (i.e., 25,000 shares worth Rs. 10 each), 2.5 lakhs worth of 8% preference shares, and 5 lakhs worth of 10% debentures). It is expected that the tax rate is 40%. Because "trading on equity" will be used, proposal "B" will result in higher earnings per share. Due to the usage of debentures and preference capital for capital raising consultants, plan B's profits per share (EPS) are Rs. 4.00 as opposed to proposal A's Rs. 1.50, as indicated in the accompanying table.
