Page 87 - DMGT409Basic Financial Management

Basic Financial Management

Notes 4. Period of Finance: If the fi nance is required for a very long time, equity shares should be
issued because it is a permanent source. If the funds are required only for a short period,
short term debt may be raised.
5. Requirement of Investors: The Company requiring large amount of capital must issue
different kinds of securities to suit the requirements of different investors.

Example: Regular income bonds, deep discount bonds, partly convertible bonds, equity
shares, preference shares etc.
6. Size of the Company: Small companies and companies with low credit ratings must rely
more on equity capital market as it is very easy to issue equity capital. On the other hand,
large companies with good credit ratings can raise debt capital easily.

7. Market Sentiments: This is another factor influencing the capital structure decision. When
there is a boom in the capital market it is very easy to issue equity capital. But when in the
market bear conditions prevail, people will look for safety. So only debt instruments with
good credit rating can be issued during such periods.

8. Cash Flow Ability: The issue of debt depends on the future cash flow ability of the
company.
9. Floating Costs: Floatation costs are incurred when the funds are raised externally. So
retained earnings do not involve fl oatation costs. Floatation costs for the issue of share is
more than that of debentures and bonds. Further the floatation costs are much less when

the company issues securities on private placement basis instead of public issue.

5.4 Concept of Leverage

As we have seen in the above discussion, that a firm can raise its required finance either equity

or debt or both the sources. While constructing capital structure, a firm can use fixed cost bearing

securities for maximisation of shareholder ‘ wealth. Leverage has been defined as, the action of a

lever and mathematical advantage gained by it. In other words, leverage allows accomplishing
certain things that are otherwise not possible. The concept is valid in business also. From the

financial management point of view, the term leverage is commonly used to describe the fi rm’s

ability to use fixed cost assets or sources of funds to magnify the returns to its owners.
There are two types of leverages, such as:
1. Operating leverage
2. Financial leverage
5.4.1 Operating Leverage

Operating leverage may be defined as the firm’s ability to use operating costs to magnify the

effects of changes in sales on its earnings before interest and taxes. Operating leverage is associated
with investment (assets acquisition) activities. Hence, operating leverage results from the present

fixed operating expenses with in firm’s income stream. The operating costs are categorised into

three:
1. First: Fixed costs, which do not vary with the level of production, they must be paid
regardless of the amount of revenue available.

Example: Depreciation plant and machinery, buildings, insurance, etc.

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