Introduction to Corporate Finance and Capital Structure
Corporate finance studies how a company raises, invests and returns funds. The exam tests fixed versus working capital, the difference between capital structure and financial structure, and the effect of trading on equity.
The three decisions
- Investment: choosing assets; fixed capital for land, plant and machinery, working capital for stock, debtors and cash.
- Financing: choosing the mix of owned and borrowed funds.
- Dividend: deciding how much profit to retain.
- Debt and preference capital carry a fixed charge, so they lower the cost of capital but raise financial risk.
Capital structure vs financial structure
- Capital structure = long-term sources only: equity share capital, preference share capital, reserves and surplus, debentures and long-term loans.
- Financial structure = capital structure plus current liabilities such as creditors and bills payable. Capital structure is therefore a subset.
- An optimum capital structure minimises the weighted average cost of capital and maximises the market value of shares.
Worked example
A company has ₹50,00,000 in equity (50,000 shares of ₹100) and needs ₹25,00,000 more. EBIT is ₹9,00,000 and tax is 25%. Option A, issue 25,000 equity shares: PAT = ₹6,75,000; EPS = ₹6,75,000 ÷ 75,000 = ₹9. Option B, issue 12% debentures: interest ₹3,00,000; PAT = ₹4,50,000; EPS = ₹4,50,000 ÷ 50,000 = ₹9. The company is indifferent. If EBIT rises to ₹12,00,000, Option A gives EPS of ₹12 while Option B gives (₹9,00,000 × 0.75) ÷ 50,000 = ₹13.50, so debt is better. That magnification is trading on equity.
Traps
- Treating creditors as part of capital structure - they belong to financial structure.
- Confusing over-capitalisation (earnings insufficient to justify the capital employed) with a simple cash shortage.