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Sources of capital on the basis of ownership & Cost Of Borrowed Capital & Leverages

  2. SOURCES OF CAPITAL  Sources of finance for business are equity, debt, debentures, retained earnings, term loans etc.These sources of funds are used in different situations.They are classified based on time period, ownership and control, and their source of generation.  Today we are going to discuss only about sources of capital based on ownership and control.
  3. Ownership And Control  These are the two most important consideration while selecting a source of funds for the business.Whenever we bring in capital, there are two types of costs – one is the interest and another is sharing ownership and control.  Ownership and control classify sources of finance into owned and borrowed capital.
  4. Owned Capital  Owned capital is also known as equity/owner’s fund. It is sourced from promoters of the company or from the general public by issuing new equity shares.  Who are Promoters? Promoters start the business by bringing in the required money for a startup.
  5. Sources of owned capital  1. EquityCapital: Equity or shares are a unit of ownership in a company, and equity capital is raised by issuing shares to shareholders. It is also referred to as share capital  Equity capital is also called as residual capital.This means that shareholders have last right on the assets of a company.  The equity capital of a company is not constant as it keeps changing due to various corporate events, such as a rights issue and additional issuance of shares.
  6. 2. Preference capital  2. PreferenceCapital:The Preference Capital is that portion of capital which is raised through the issue of the preference shares.This has certain characteristics of equity and certain attributes of debentures.  Shareholders with these shares must be paid before those with equity shares when a company is paying dividends or if it goes bankrupt
  7. 3. Retained Earnings(RE)  Retained earnings (RE) is the amount of net income left over for the business after it has paid out dividends to its shareholders. A business generates earning that can be positive (profits) or negative (losses)  Retained Earnings= Beginning Period RE+ Net income (or loss)- Cash dividends- Stock Dividends.
  8. Retained Earnings(Cont’d)  Often the profit earned by a company is paid out to shareholders, but it can also be reinvested back into the company for growth purposes.The money not paid to shareholders counts as retained earnings.  The decision to retain the earnings or to distribute it among the shareholders is usually left to the company management.
  9. 4. Convertible Debentures  A convertible debenture is a kind of long- term debt which can be transformed into stock after a certain period of time.  A convertible debenture is usually an unsecured bond or a loan as in there is no primary collateral interlinked to the debt.
  10. Convertible Debentures(cont’d)  Some companies may use more debt than equity to raise capital .  The option of converting debentures into equity shares lies with the holder.  A convertible debenture will provide regular interest income via coupon payments and repayment of the principal amount at maturity.
  11. 5. Venture Capital Fund  Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long term growth potential.  It does not always take a monetary form; it can also be provided in the form of technical or managerial expertise.
  12. Advantages of owned capital  It is a long-term capital which means it stays permanently with the business.  There is no burden of paying interest or installments like borrowed capital. So, the risk of bankruptcy also reduces. Businesses in infancy stages prefer equity for this reason.
  13. Disadvantages of Owned Capital  The cost of equity capital is high since the equity shareholders expect a higher rate of return.  The cost of issuing equity shares is usually costlier than the issue of other types of securities.  The cost of equity is relatively more, since the dividends are paid out of profit after tax, but the interest payments are tax-deductible.
  14. Sources Of Borrowed Capital  Borrowed or debt capital is the finance arranged from outside sources.These sources of debt financing include the following:  Financial institutions,  Commercial banks or  Debentures
  15. Let’s Understand Borrowed Capital  Borrowed capital can be in the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds.  In all the cases, a borrower must pay an interest rate as the cost of borrowing. Typically, debt is secured by collateral.  Borrowed capital may also take the form of a debenture, however, and in that case, it is not secured by an asset.
  16. Advantages and Downside Of Borrowing Capital  There is no dilution in ownership and control of the business.  The cost of borrowed funds is low since it is a deductible expense for taxation purpose which ends up saving on taxes for the company.  It gives the business the benefit of leverage.  The downside is the potential for greater losses, given that the borrowed money must be paid back somehow, regardless of the investment's performance.
  17.  In General Terms, Leverage means the use of force and effects to produce a more than normal results from a given action.  In Other Words, Leverage is the advantage generated by using a lever.  Example, Using a Jack to Lift a Car.  In Finance, Leverage is the use of fixed costs to magnify the potential return to a firm.  Two Types Of Fixed Costs :  Fixed Operating Costs = Rent, Salaries, etc.  Fixed Financial Costs = Interest Costs From Debt.
  18.  Leverage Can Magnify Returns to Common Stockholders but can also Increase Risk.  Management has almost complete control over this risk introduced through the use of leverage (fixed costs) .  The Degree in the use of Leverage depends on management’s attitude toward risk and the nature of its business, among others.  Three types of Leverage with reference to the firm’s income statement: 1. Operating Leverage 2. Financial Leverage 3. Combined (Total) Leverage  Leverage is measured on the profitability range of operations.
  19.  Leverage is an essential tool a company's management can use to make the best financing and investment decisions.  It provides a variety of financing sources by which the firm can achieve its target earnings.  Leverage is also an important technique in investing as it helps companies set a threshold for the expansion of business operations.  For example, it can be used to recommend restrictions on business expansion once projected return on additional investment is lower than cost of debt. Leverage provides the following benefits for businesses:
  20.  Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue.  A business that generates sales with a high gross margin and low variable costs has high operating leverage.  A firm with relatively high fixed operating costs will experience more variable operating income if sales change.  Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue.  Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product.  Low-operating-leverage companies may have high costs that vary directly with their sales but have lower fixed costs to cover each month.
  21. Operating Leverage can be calculated with the help of the following formula:- OL = Contribution/EBIT Where,  OL = Operating leverage  EBIT = Earnings Before Interest & Taxes.
  22. Characteristics of Operating Leverage  It is related to the assets side of balance sheet.  It is directly related to break-even point.  It is related to selling price and variable costs.  It is involves business risk.
  23.  The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a company’s operating income to its sales.  This financial metric shows how a change in the company’s sales will affect its operating income.  The degree of operating leverage (DOL) at any level of output expressed as the ratio of the percentage change in operating profits to percentage change in sales.
  24.  The degree of operating leverage can be calculated in several different ways. 1. First, we can use the formula from the definition of the 2. Since the operating leverage ratio is closely related to the company’s cost structure, we can calculate it using the company’s contribution margin. The contribution margin is the difference between total sales and total variable costs.
  25. 3. If there is available information about the cost structure of a company, we can use the following formula: Where: •Q – the number of units •P – the price per unit •V – the variable cost per unit •F – the fixed costs
  26.  The management of ABC Corp. wants to determine the company’s current degree of operating leverage. The company sells 10,000 product units at an average price of $50. The variable cost per unit is $12, while the total fixed costs are $100,000. The company’s DOL is: The DOL indicates that every 1% change in the company’s sales will change the company’s operating income by 1.38%.
  27.  Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.  If any change in the sales, it will lead to corresponding changes in profit.  Operating leverage helps to identify the position of fixed cost and variable cost.  Operating leverage measures the relationship between the sales and revenue of the company during a particular period.  Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.  Operating leverage describes the over all position of the fixed operating cost.
  28.  Leverage activities with financing activities is called financial leverage.  Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.  Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”.  It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.  The use of fixed-cost sources of financing (debt, preferred stock) rather than variable- cost sources (common stock).
  29. Financial Leverage can be calculated with the help of the following formula:- FL = OP/PBT Where,  FL = Financial leverage  OP = Operating profit (EBIT)  PBT = Profit before tax.
  30. Characteristics of Financial Leverage  It is related to liabilities side of balance sheet.  It is the mix of methods of financing.  It shows effect of changes in operating profits on earnings per share due to fixed financial charges.  It involves financial risk.
  31.  The degree of financial leverage is a financial ratio that measures the sensitivity in fluctuations of a company’s overall profitability to the volatility of its operating income caused by changes in its capital structure.  The degree of financial leverage is one of the methods used to quantify a company’s financial risk (the risk associated with how the company finances its operations).
  32.  The degree of financial leverage can be calculated in several different ways. 1. The choice of the calculation method depends on the goals and context of the analysis. For example, a company’s management often wants to decide whether it should or should not issue more debt. In such a case, net income would be an appropriate measure of the company’s profitability:
  33. 2. If an investor wants to determine the effects of the company’s decision to incur additional leverage, the earnings per share (EPS) is a more appropriate figure because of the metric’s strong relationship with the company’s share price. 3. There is a formula that allows calculating the degree of financial leverage in a particular time period:
  34.  Suppose ABC Corp. is preparing to launch a new project that will require substantial external financing. The company’s management wants to determine whether it can safely issue a significant amount of debt to finance the new project. Currently, the company’s EBIT is $500,000, and interest payments are $100,000. In order to make the decision, the company’s management wants to examine its degree of financial leverage ratio: It shows that a 1% change in the company’s leverage will change the company’s operating income by 1.25%.
  35.  Financial leverage helps to examine the relationship between EBIT and EPS.  Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.  Financial leverage locates the correct profitable financial decision regarding capital structure of the company.  Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.  If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.