Types of Capital | Leverage
1 Types of Capital | Leverage
Types of Capital
Common stock holders of a corporation are it’s residual owners, their claim to income and assets comes after emendators and preferred stock holder’s have been paid in full. As a result, a stock holder’s return on investment is less certain than the return to leader or to a preferred stock holder. On the others hand, the share of a common stock can be authorized either with or without per value. The per value of a stock is merely a stated figure in the corporate chapter and is of little economic significance. A company should not issue stock at a price less than par value because stockholders who brought stock for less than par value would be liaber to creditors they paid and the par value (Van Horne: 1997).
The equity share capital is the ownership capital does not carry any special or preferential rights in the payment of annual dividend or repayment of capital. The rate of dividend on such capital is not fixed. Dividend on equity capital is paid out of the residual profits left after paying interest on debenture and preference share divided. Similarly, equity shareholders are paid at the time of winding up of the company only after all the prior claims have been settled. Therefore, equity shareholders are the real risk bearer. But they share in the increasing profit of the company. They also enjoy voting rights in the management and control of the company.
Preference share capital curries certain special rights or priority rights. Firstly, dividend at a fixed rate payable on these shares before any dividend is paid on equity shares. Secondary, at the time of winding up of the company, capital is repaid to preference share holders prior to the return of equity capital.
Debenture are certificates issued by a company acknowledging debt a specified amount to the person named in it. Debenture includes debenture stocks, bonds, and any other securities of company representing a loan amount. Therefore a periodic payment of interest at the specified rate is to be paid on debenture. Apart from the interest the principle amount is also refunded to the holders, which is known as redemption of debenture. Thus, the capital with fixed interest change is called debt and the payment of interest as well as principle on debt is an obligation of the firm that must be paid before any remaining profit after taxes is available for shareholders. (Copeland and Weston. 1990:567). The use of debt of leverage at once provides the potential of increasing the shareholders earning as well as creating the risk of loss of them. Therefore, debt is the two edged sword.
The term ‘leverage’ results from the use of fixed cost assets or fund to magnify returns to the firm’s owners/ changes in leverage result in changes in level of return and associates risk. Generally, increase in leverage results in increase in return and risk, where as decrease in leverage results in decrease return and risk. The amount of leverage in firm’s capital structure is the mix of long-term debt and equity maintained by the firm.
The three basic types of leverage can be defined with leverage to the firm’s income statement. These are operating leverage, financial leverage and total leverage which are clearly labeled in following general income statement format:
General Income Statement Format and Types of Leverage
Operating Sales revenue
Leverage Less: Cost of goods sold gross profit
Total Less: Operating expenses
Leverage Earning before interest and tax (EBIT)
Financial Net profit before tax
Leverage Less: Taxes
Net profit after tax
Less: Preferred stock dividends earning available to common stockholders Earning per share (EPS)
From above table, it is clear that operating leverage is concerned with the relationship between the firm’s sales revenue and it’s operating interest and taxes of EBIT. While financial leverage is concerned with the relationship between the firms earnings before interest and tax (EBIT) and it’s earnings per share of common stock. Our study is combined with only financial leverage.
Financial leverage result from the presence of fixed financial cost in the firms in come stream. It can be defined as the potential use of fixed financial cost to magnify the effect of changes in earning before inte4rest and taxes on the firm’s earning per share. The two fixed financial cost normally found on the firm’s income statement are:
Interest of debt and
Preferred stock dividend
These changes must be paid regard less of the amount of EBIT available to pay them.
The effect of financial leverages is such that an increase in the firms EBIT result in a greater than proportional increase in the firm’s earning per share while decrease in the firm’s EBIT result in a more than proportional decrease in EPS.
Measuring the degree of financial leverage (DEL)
The degree of financial leverage is the numerical measure of the firm’s financial leverage. It can be computed in fashion similar to that used to measure the degree of operating leverage. It can be derived by using following formula.
D.F.L. = EBIT/ EBT
Whenever DFL is grater than 1, there is financial leverage.
Leverage ratio measures the contribution of financing by owners compared with financing provided by the out siders. They also provide some measure of the risk of debt financing by the calculation of the leverage of fixed charges.
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