Trading on EquityTrading on Equity

The use of the fixed charges sources of The use of the fixed charges sources of funds such as debt and preference share funds such as debt and preference share capital along with the owner’s equity in the capital along with the owner’s equity in the capital structure is described as “trading capital structure is described as “trading on equity” or “financial leverage” or on equity” or “financial leverage” or “gearing”.“gearing”.

Where debt capital is more than 50% of Where debt capital is more than 50% of total capital it is called highly geared total capital it is called highly geared capital structure.capital structure.

Long Term Capital sourcesLong Term Capital sources

Equity Shares:Equity Shares:

Ordinary equity shares represent the Ordinary equity shares represent the ownership position in the company.ownership position in the company.

The portion of profit given to equity The portion of profit given to equity shareholders are called “Dividend”shareholders are called “Dividend”

The Rights of Ordinary The Rights of Ordinary ShareholdersShareholders

attend general meetings of their company; attend general meetings of their company; vote on election of the directors of their company; vote on election of the directors of their company; vote on the appointment, remuneration and removal of auditors; vote on the appointment, remuneration and removal of auditors; receive the annual accounts of their company and the report of its receive the annual accounts of their company and the report of its

auditors; auditors; receive a share of any dividend distributed; receive a share of any dividend distributed; vote on important matters such as a change in their company’s vote on important matters such as a change in their company’s

authorized share capital, the repurchase of its shares, or take-over authorized share capital, the repurchase of its shares, or take-over bid; bid;

receive a share of any assets remaining after their company has receive a share of any assets remaining after their company has been liquidated; been liquidated;

participate in a new issue of shares in their company (the participate in a new issue of shares in their company (the preemptive right) preemptive right)

Preference sharesPreference shares

It is often considered to be a hybrid security It is often considered to be a hybrid security since it has both the advantages of ordinary since it has both the advantages of ordinary shares and debentures.shares and debentures.

Features:-Features:-

* Dividend rate is fixed* Dividend rate is fixed

* Dividends are not deductible for tax purposes* Dividends are not deductible for tax purposes

* Preference shareholders have claims on income * Preference shareholders have claims on income and assets prior to ordinary shareholdersand assets prior to ordinary shareholders

Difference between Equity Capital Difference between Equity Capital and Preference capital and Preference capital

Equity share holders are the owners of the Equity share holders are the owners of the company. They have the right to receive company. They have the right to receive dividends. Preference share holders has dividends. Preference share holders has the preference to get fixed rate of interest the preference to get fixed rate of interest of profit for their shares.  of profit for their shares. 

preference share holders have no voting preference share holders have no voting rights . but equity share holders have rights . but equity share holders have voting rights.voting rights.

equity share holders who have a major no. equity share holders who have a major no. of shares have a right to attend a board of of shares have a right to attend a board of director meeting but in case of preference director meeting but in case of preference share holders doesn't get any right. share holders doesn't get any right.

Debentures Debentures

A Debenture is a long-term debt instrument used A Debenture is a long-term debt instrument used by governments and large companies to obtain by governments and large companies to obtain funds. It is similar to a bond except the funds. It is similar to a bond except the securitization conditions are different. A securitization conditions are different. A debenture is usually unsecured in the sense that debenture is usually unsecured in the sense that there are no liens or pledges on specific assets. there are no liens or pledges on specific assets. It is however, secured by all properties not It is however, secured by all properties not otherwise pledged. In the case of bankruptcy otherwise pledged. In the case of bankruptcy debenture holders are considered general debenture holders are considered general creditors creditors

Term LoansTerm Loans

Term loans represents long term debt with Term loans represents long term debt with a maturity of more than one year.a maturity of more than one year.

They are obtained from banks and They are obtained from banks and specially created financial institutionsspecially created financial institutions

They are generally obtained for financing They are generally obtained for financing large expansion, modernization or large expansion, modernization or diversification projects. Therefore, this diversification projects. Therefore, this method of financing is called “ Project method of financing is called “ Project financing”.financing”.

Capital Structure Capital Structure

The capital structure of a company is the The capital structure of a company is the particular combination of debt, equity and particular combination of debt, equity and other sources of finance that it uses to other sources of finance that it uses to fund its long term financing. fund its long term financing.

The capital structure is how a firm finances The capital structure is how a firm finances its overall operations and growth by using its overall operations and growth by using different sources of funds. different sources of funds.

DEFINITIONDEFINITION

The permanent long-term financing of a company, including long-term debt, common stock and preferred stock, and retained earnings. It differs from financial structure, which includes short-term debt and accounts payable. .

Capital Structure TheoriesCapital Structure Theories

Net Income Approach (NI Approach)Net Income Approach (NI Approach)

*A firm that finances its assets by equity *A firm that finances its assets by equity and debt is called a levered firm. On the and debt is called a levered firm. On the other hand a firm that uses no debt and other hand a firm that uses no debt and finances its assets entirely by equity is finances its assets entirely by equity is called unlevered firm.called unlevered firm.

*it is known as relevance approach.*it is known as relevance approach.

AssumptionsAssumptions

Cost of Debt (Kd) and cost of equity (Ke) remain Cost of Debt (Kd) and cost of equity (Ke) remain constand.constand.

Cost of Debt (Kd) is always lesser than cost of Cost of Debt (Kd) is always lesser than cost of equity (Ke).equity (Ke).

Value of the firm(V) =value of debt + value of Value of the firm(V) =value of debt + value of equityequity

V= B+ SV= B+ S B = value of debt ; S = value of equityB = value of debt ; S = value of equity Value of equity= Value of equity= Equity EarningsEquity Earnings cost of Equitycost of Equity

Cost of equity is also known as equity Cost of equity is also known as equity capitalization rate.capitalization rate.

Equity earnings = EBIT- InterestEquity earnings = EBIT- InterestEBIT= Earnings Before Interest and TaxEBIT= Earnings Before Interest and Tax Interest is calculated on Debenture capitalInterest is calculated on Debenture capitalKo(overall cost of capital)= Ko(overall cost of capital)= EBITEBIT

VV

Net Operating Income AppraochNet Operating Income Appraoch

Value of the firm(V) =Value of the firm(V) =EBITEBIT

KoKoValue of equity= Value of the firm – Value Value of equity= Value of the firm – Value

of debtof debtcost of Equity = cost of Equity = Equity EarningsEquity Earnings

Value of EquityValue of Equity Ko=(Kd X Ko=(Kd X Value of debt Value of debt ) + ( Ke X ) + ( Ke X Value of equity Value of equity ))

Value of the firm Value of the firmValue of the firm Value of the firm

Traditional ApproachTraditional Approach

Value of firm = value of equity + value of Value of firm = value of equity + value of debtdebt

Value of equity= Value of equity= equity earningsequity earnings

cost of equitycost of equity