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Preface
T
he main objective of any firm on the verge of financing its capital needs either
during the initial formation phase or during the operation phase should be to
obtain an optimum capital structure. To quote Ezra “optimum leverage is that
mix of debt and equity which will maximize the market value of the company’s share
and minimize the overall cost of capital.”Hence a capital structure should be framed
with an objective of maximizing the interest of the ordinary shareholders, maximizing
the EPS of the company.
“However there is no tailor made capital structure for all the business enterprise.”
A company’s capital structure is a function of the nature of its business and the
degree of risk faced by the particular business over a period of time. Therefore prior
to making any financing decisions, beside over viewing the general theory of
finance, the circumstance of the business enterprise in question has to be evaluated.
Moreover when the funds are being raised in the recessionary phase, whilst the
capital market is plagued by scarcity of loanable funds and high rate of interest,
every decision have to be taken shrewdly. This is so because making an investment
in recessionary period through mortgage of assets is quite risky as the economic
environment is unpredictable. Also in bearish conditions as investors often prefer to
play safe so as to avoid making capital loss, interest rates are pretty high.
Similarly prior to making any investment promises the return on capital employed
should also be judiciously evaluated. The return on investment should be higher than
the cost of capital as not achieving this will lower the wealth of the shareholder and
concurrently reduces the EPS. Techniques like NPV and IRR help to better judge the
investment alternatives.
Henceforth every aspect has to be evaluated clearly before taking decision regarding the
selection of the appropriate mix for financing the project cost.
The following are the financing mix considered by the firm in prospect.
Post Expansion
structure
Equity share at Rs 85,00,00 80,00,00 1,10,00,0 60,00,00 60,00,00
100 each 0 85,00,000 0 00 0 0
12% Preference 30,00,00 30,00,00 30,00,00 30,00,00
share 0 30,00,000 0 30,00,000 0 0
15% Preference 25,00,00 50,00,00
share 0 - - - 0 -
1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0
15% Debenture 00 00 00 00 00 00
30,00,00 50,00,00
18% Debenture - 25,00,000 0 - - 0
2,50,00, 2,50,00,0 2,50,00, 2,50,00,0 2,50,00, 2,50,00,
Total 000 00 000 00 000 000
Plan A, Plan E and Plan F show negative EPS at (-0.7058), (-7.25) and (-2.25)
respectively, owing to the adverse net earnings. Hence these alternatives cannot
be considered by the management for financing the project cost as this will not
lead to maximization of EPS.
Similarly though Plan B and Plan C have positive EPS, the management should
opt for Plan E as it yields a maximum EPS.