Introduction
The central issue before the Fiancé team
is to determine OPTIMUM CAPTAL STURTURE. That
is proportion of Equity & Funds “ .
The Finance Manger must strive to obtain the BEST
FINANCE MIX OT OPTIMUM CAPTIAL STURCTURE for his
or there firm, which consists Equity & Debt.
Equity
The Financial interests of the owners are called
owners’s EQUITY . The owner’s interest
is residual in the nature, reflecting the excess
of the firm’s assets over it liabilities.
Initially. Owner’s equity arises on account
of the funds invested by them. But it changes
due to the earnings of the firm and their distribution.
Owner’s equity will increase when firm make
earnings and retains whole or part.
Debt
It is an obligation on the part of owners or
enterprise payable in period of time. It may be
long term or short term.
Long-term debt usually represents borrowing for
a long period of time.
Example: Debentures, Bonds and Long-term loans
from financial institutions.
Short-term debt usually represents borrowing
for a short period time (< one year).
Example: Working capital loan, Receivable loan,
Credit card loan and short-Period
loan etc.
Financial Leverage
The Firm’s Capital structure is considered
to be optimum when the market value of shares
is maximized. The process of magnifying the shareholder’s
return through the use of debt is called “Financial
Leverage”.
The use of debt affects the return and risk of
shareholders it may increase the return of equity
funds but it always increase the risk. A proper
balance will have to be struck between RETURN
& RISK, the market value per share will be
maximized with minimum risk, the market value
per share will be maximized and the firm’s
capital structure would be considered optimum.
Advantages of Equity
• There is no legal obligation to repay
the Principal in near future
• No interest charges to be paid, whether
Profit or Loss arising in a year.
• High debt-burdened enterprise find difficult
in securing funds for future
• Absolute risk-free for the company, who
have less debts and no fear for insolvency
• Absolute control by owners, who have invested
the money.
• In lower debt enterprises, owners earnings
will be magnified
Advantage of Debt
• Obligation to the owners to run the affairs
of business more professionally
• Tax exemption available in case funds
sourced thru debts
• Misuse of resources, when equity funds
diverted for working capital
The advantage of Equity is drawbacks of debts
and vice versa.
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