10 Questions
What is the primary characteristic of Participating Preference Shares?
Residual claim on company's assets
Which type of debenture is secured against a specific property?
Secured or Mortgaged Debentures
What is the primary advantage of issuing Zero Coupon Bonds?
Lower issue price
What is the key characteristic of Equity Shares in terms of dividend payment?
Dividend payment is not obligatory
What is the primary feature of Convertible Preference Shares?
Convertible to Equity Shares
What is the primary benefit of a company issuing Redeemable Debentures?
Reduced debt repayment burden
What is the primary characteristic of Irredeemable Debentures?
Not repayable during the company's lifetime
What is the primary advantage of a company having a mix of Equity and Debt capital?
Optimized capital structure
What is the primary characteristic of Non-Participating Preference Shares?
No claim on company's assets
What is the primary benefit of issuing Bearer Debentures?
Easier transferability
Study Notes
Retaining / Loss of Control
- To avoid dilution of control of equity shareholders, certain restrictions are imposed on debt agreements.
Factors Determining Capital Structure
- EBIT-EPS analysis: increasing EBIT to meet fixed cost commitments due to debt to maintain EPS.
- Growth and stability of sales: increasing debt level as committed payments can be honored easily.
- Legal requirements: types of share capital, authorized, subscribed, and paid-up capital, alteration of share capital, bonus shares, private placement of shares, voting rights, and disclosure requirements.
- Purpose of financing: productive (debt and preference) and non-productive (equity).
- Periods of financing: permanent (equity) and non-permanent (debt and preference).
- Market sentiments: bullish vs. bearish sentiments, market sentiment influencing debt levels.
- Nature and size of a firm: technology startups relying more on equity, economies of scale, diversification, and market perception of firm size.
Leverages
- Financial leverage: ability of the firm to use fixed financial charges to magnify the effects of changes in EBIT on EPS.
- Trading on equity: earning more on assets purchased with debt than the fixed cost of debt (favourable leverage).
- Unfavourable leverage: not earning enough on assets purchased with debt to cover the fixed cost of debt.
- Financial leverage formula: EBIT/PBT or PBT/EPS.
- Degree of financial leverage (DFL): %change in EPS / %change in EBIT.
Combined Leverage
- Arises from the existence of fixed operating costs (operating leverage) and fixed financial charges (financial leverage).
- Combined leverage formula: Contribution / EBT or EBIT – I.
- Degree of combined leverage (DCL): Degree Operating Leverage (DOL) x Degree of Financial Leverage (DFL).
- DCL formula: %change in EPS / %change in Sales.
Types of Preference Shares
- Participating preference shares: have a residual claim on assets.
- Non-participating preference shares: have no claim on residual assets.
- Convertible preference shares: can be converted to equity shares.
- Non-convertible preference shares: cannot be converted to equity shares.
Debt Capital
- Unsecured debentures: no security on assets, equivalent to unsecured creditors.
- Secured or mortgaged debentures: secured against a specific property.
- Bearer debentures: easily transferable.
- Registered debentures: can be transferred only by a normal transfer deed.
- Redeemable debentures: must be repaid by a set time.
- Irredeemable debentures: not repayable or redeemable by a company during its lifetime.
- Convertible debentures: can be converted to equity shares.
- Zero-interest bonds: can be converted to equity shares.
- Zero-coupon bonds: sold at a deep discount by the issuing company.
This quiz covers the key factors determining capital structure, including EBIT-EPS analysis and its impact on EPS and debt financing.
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