An understanding of capital gearing and equity trading

“After severe financial crises in the economy, it is of great importance for a company to have a perfect mix of different sources of capital to ensure good returns and overcome the depth of losses.”

Here are some key terms related to a company’s financial system that have been defined:

CAPITAL STRUCTURE

The type of securities to be issued and the proportionate amounts that make up the capitalization are known as the capital structure or financial structure.

Capital structure refers to the proportion of different types of securities issued by a company to raise long-term financing. Thus, the capital structure designates: (1) the types of securities issued (stocks, preferred stocks and debt securities) and (ii) the relative proportion of each security type. In other words, the capital structure represents the proportion of equity and debt used to fund a company’s operations. An appropriate balance must be struck in the following securities or sources of funding to maximize the wealth of the company’s shareholders:

(a) equal shares,

(b) preferred stock and

(c) Notes

Characteristics of a solid capital structure

A company’s capital structure is considered optimal when the ratio of debt to equity is such that returns for shareholders are maximized. Such a structure would vary from company to company depending on the nature and size of the business, availability of funds from different sources, efficiency of management, etc.

A SOLID CAPITAL STRUCTURE SHOULD HAVE THE FOLLOWING CHARACTERISTICS:

(i) MAXIMUM RETURN.

(ii) LESS RISK.

(iii) FLEXIBILITY

(iv) ECONOMY.

(v) DYNAMIC.

FINANCIAL LEVERAGE OR CAPITAL GEARING

A company can raise capital by issuing three types of securities: (a) stocks, (b) preferred stock, and (c) debt securities. Preferred stock has a fixed dividend rate and debt has a fixed interest rate. The shares will be paid as a dividend from the earnings remaining after paying interest on the debentures and as a dividend on preferred stock. Therefore, the dividend on stocks can fluctuate from year to year. Stocks are known as variable-yield securities and debt and preferred stocks as fixed-yield securities. When the yield on fixed income is lower than the company’s win rate, the yield on stocks is higher. This phenomenon is known as financial leverage or capital debt.

So, financial leverage is an arrangement whereby fixed income securities (debt and preferred stock) are used to raise cheaper funds to increase returns for shareholders. It may be noted that a lever is used to lift something heavy by applying less force than would otherwise be required.

Capital gearing describes the relationship between different types of securities and the total capitalization. A company’s capitalization is leveraged heavily when equity is a small percentage of total capitalization, and leveraged low when equity dominates the capital structure.

Capital gearing is calculated by finding the ratio of the amount of equity (representing variable rate securities) to the total number of securities issued by a company (stocks, preferred stocks and debt securities). Here the capital structure of two different companies is shown. Both companies have issued the entire securities worth Rs. 20,00,000 and they have shares worth Rs. 5,00,000 and Rs. 15,00,000 respectively, Company A is heavily indebted as the ratio of equity to total capitalization is low, namely 25%. But in the case of Company B, that ratio is 75%, so it’s low in debt.

ANALYSIS OF CAPITAL GEARING

company

(R)

(a) Share capital 5,00,000

(b) Notes 15,00,000

(c) Total Capitalization 20,00,000

(d) Capital Gearing (a /c × 100) = 5,00,000/ 2,00,000 × 100

= 25% (high ratio)

The various securities issued should have such a ratio to total capitalization that the capital structure is safe and sound.

Shares should be issued when there is uncertainty about earnings. Preferred stocks, especially the cumulative ones, should be issued when a fairly good average return is expected. Debentures should be issued when the company expects significantly higher future earnings, in order to pay interest to debtholders and enhance shareholder returns.

TRADE ON EQUITY

Stock trading is an arrangement in which financial management raises funds through the issuance of securities that carry a fixed rate of interest (or dividend) below the company’s average earnings. This is done to increase the returns on the stocks.

Let’s assume that a company needs an investment of Rs. 10 lakhs to earn Rs. 2.5 lakhs @ 25 per cent pa To raise this amount we can consider two proposals, namely (A) issuing 1 lakhs shares of Rs. 10 each: and (B) issuing shares worth Rs. 2.5 lakhs (ie 25,000 shares at Rs. 10 each), 8 per cent preference shares valued at Rs. 2.5 lakhs and 10 per cent debentures valued at Rs. 5 lakhs. The tax rate is assumed to be 40 percent. Earnings per share on Proposal “B” will be higher due to the application of “Equity Trading”. As shown in the table below, earnings per share (EPS) under Proposal B is Rs. 4.00 compared to Rs. 1.50 under Proposal A due to the use of debentures and preferred capital to raise funds.

EFFECT OF TRADING ON EQUITY

  • Details proposal
  • Earnings Before Interest and Tax (EBIT) Rs. 2,50,000
  • Less interest on bonds (10%) Zero
  • Earnings after interest and before taxes 2,50,000
  • Less tax (40%) 1,00,000
  • Earnings after interest and taxes 1.50.000
  • Less preferred dividend (8%) Nil
  • Income available to equity shareholders 1,50,000
  • Number of shares outstanding 1,00,000
  • Earnings per share (EPS) Rs. 1.50