Trading on Equity

 The use of the fixed charges sources of

funds such as debt and preference share
capital along with the owner’s equity in the
capital structure is described as “trading
on equity” or “financial leverage” or
“gearing”.
 Where debt capital is more than 50% of
total capital it is called highly geared
capital structure.
 Long Term Capital sources
 Equity
Shares:
Ordinary equity shares represent the
ownership position in the company.
The portion of profit given to equity
shareholders are called “Dividend”
 The Rights of Ordinary
Shareholders
 attend general meetings of their company;
 vote on election of the directors of their company;
 vote on the appointment, remuneration and removal of auditors;
 receive the annual accounts of their company and the report of its
auditors;
 receive a share of any dividend distributed;
 vote on important matters such as a change in their company’s
authorized share capital, the repurchase of its shares, or take-over
bid;
 receive a share of any assets remaining after their company has
been liquidated;
 participate in a new issue of shares in their company (the
preemptive right)
 Preference shares
 It is often considered to be a hybrid security
since it has both the advantages of ordinary
shares and debentures.
 Features:-

* Dividend rate is fixed

* Dividends are not deductible for tax purposes
* Preference shareholders have claims on income
and assets prior to ordinary shareholders
 Difference between Equity Capital
and Preference capital
 Equity share holders are the owners of the
company. They have the right to receive
dividends. Preference share holders has
the preference to get fixed rate of interest
of profit for their shares.
 preference share holders have no voting
rights . but equity share holders have
voting rights.
 equityshare holders who have a major no.
of shares have a right to attend a board of
director meeting but in case of preference
share holders doesn't get any right.
 Debentures
A Debenture is a long-term debt instrument used
by governments and large companies to obtain
funds. It is similar to a bond except the
securitization conditions are different. A
debenture is usually unsecured in the sense that
there are no liens or pledges on specific assets.
It is however, secured by all properties not
otherwise pledged. In the case of bankruptcy
debenture holders are considered general
creditors
 Term Loans
 Term loans represents long term debt with
a maturity of more than one year.
 They are obtained from banks and
specially created financial institutions
 They are generally obtained for financing
large expansion, modernization or
diversification projects. Therefore, this
method of financing is called “ Project
financing”.
 Capital Structure
 The capital structure of a company is the
particular combination of debt, equity and
other sources of finance that it uses to
fund its long term financing.
 The capital structure is how a firm
finances its overall operations and growth
by using different sources of funds.
 DEFINITION

 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 Theories
 Net Income Approach (NI Approach)
*A firm that finances its assets by equity
and debt is called a levered firm. On the
other hand a firm that uses no debt and
finances its assets entirely by equity is
called unlevered firm.
*it is known as relevance approach.
 Assumptions
 Cost of Debt (Kd) and cost of equity (Ke) remain
constand.
 Cost of Debt (Kd) is always lesser than cost of
equity (Ke).
 Value of the firm(V) =value of debt + value of
equity
 V= B+ S
 B = value of debt ; S = value of equity
 Value of equity= Equity Earnings

cost of Equity
 Cost of equity is also known as equity
capitalization rate.
 Equity earnings = EBIT- Interest
 EBIT= Earnings Before Interest and Tax
 Interest is calculated on Debenture capital
 Ko(overall cost of capital)= EBIT

V
Net Operating Income Appraoch
 Value of the firm(V) =EBIT
Ko
 Value of equity= Value of the firm – Value
of debt
 cost of Equity = Equity Earnings

Value of Equity
 Ko=(Kd X Value of debt ) + ( Ke X Value of equity )
Value of the firm Value of the firm
 Traditional Approach
 Value of firm = value of equity + value of
debt
 Value of equity= equity earnings

cost of equity