Also known as trading on equity. Refers to a firm’s use of fixed-charge securities like debentures and preference shares in its plan of financing the assets. It helps in determining financial risk of a firm.
Regulatory role Covers a broad spectrum – entry to the business to the final result of business The reservation of industries to small scale, public and cooperative sectors. Licensing system Regulation of entry Regulation of product mix, promotional activities etc. Regulate relationship between organizations. Promotional role Building infrastructure – power, transport etc. Financial support Institutions […]
Refers to the use of fixed cost in the operation of a firm. OL may be defined as the tendency of the operating profit to vary disproportionately with sales. OL is firm’s ability to use fixed operating cost to magnify the effect of change in sales on its EBIT. OL = Contribution/Operating profit OL is […]
The main causes of under capitalisation are: Acquisition of assets during recession Under estimation of capital requirements Conservative dividend policy – higher rate of ploughing back of profits Efficient management Creation of secret reserves
Remedies for Over Capitalisation To have efficient management Redemption of preference shares Reduction of funded debts Reorganisation of equity share capital – face value of the equity shares may be reduced – utilised for writing off the fictitious assets and other over-valued assets.
The effects of under capitalisation are: On shareholders Rate of EPS will go up. The value of equity share in the market will go up. Financial reputation of the company will increase. Can expect higher dividends regularly. On company Market value of company shares will go up – increase in reputation of the company. The […]
Effects of Over Capitalisation Effects on the company Loss of goodwill – reduced earning capacity>fall of market price Poor creditworthiness – difficult to get loans or credit at cheaper rates of interest. Difficulties in obtaining capital – loss of confidence in the company. Decline in efficiency of the company Loss of market – Inflated profits […]
Causes of over capitalisation Over issue of capital Promotion, formation or development during inflation. Buying assets of lower value at higher prices. High promotion expenses – preliminary expenses. Inadequate depreciation – leaves insufficient provision for replacement of assets. Liberal dividend policy – Taxation policy – high tax rates Inadequate demand for products – bring down […]
Cost Theory Earnings Theory Meaning Capital value is determined by adding all costs. Capital value is determined based on its earning capacity. Base of theory Based on costs incurred Based on earning capacity Applicability to companies New companies Existing companies Calculation Easy and simple Difficult Superiority Not so Superior to cost theory
Factors determining the capital structure Financial leverage or trading on equity The use of long term debt increases, magnifies the EPS if the firm yields a return higher than the cost of debt. The EPS also increases with the use of preference share capital but due to the fact that interest is allowed to be […]