Understanding Equity Gear and Stock Trading

“After strong financial crises in the economy, for a corporate entity, it is quite significant to have a perfect combination of various sources of capital to ensure good returns and overcome deep losses.”

Here, some crucial terms have been defined with reference to a company’s financial system:

CAPITAL STRUCTURE

The type of securities to be issued and the proportional amounts that make up the capitalization is known as the capital structure or financial structure.

Capital structure refers to the proportion of different types of securities issued by a company to obtain long-term financing. Thus, the capital structure denotes: (1) the types of securities issued (capital shares, preferred shares and bonds), and (ii) the relative proportion of each type of security. In other words, the capital structure represents the proportion of registered capital and department capital used to finance the operations of a company. A proper balance must be obtained in the following securities or sources of financing to maximize the wealth of the company’s equity shareholders:

(a) actions of equality,

(b) preferred shares, and

(c) obligations

Characteristics of the solid capital structure

The capital structure of a company is said to be optimal when the ratio of debt to equity is such that it results in maximizing returns for equity shareholders. This structure would vary from one company to another depending on the nature and size of the operations, the availability of funds from different sources, the efficiency of management, etc.

A SOLID CAPITAL STRUCTURE MUST HAVE THE FOLLOWING CHARACTERISTICS:

(i) MAXIMUM PROFITABILITY.

(ii) LESS RISK.

(iii) FLEXIBILITY

(iv) ECONOMY.

(v) DYNAMIC.

FINANCIAL LEVERAGE OR CAPITAL LEVERAGE

A company can raise capital by issuing three types of securities: (a) equity shares, (b) preferred shares, and (c) bonds. Preferred shares have a fixed dividend rate and bonds have a fixed interest rate. Equity shares are paid dividends with the earnings remaining after the payment of interest on obligations and dividends on preferred shares. Therefore, dividends on equity shares can vary from year to year. Equity stocks are known as variable yield securities and bonds and preferred stocks as fixed yield securities. If the rate of return on the fixed-return securities is less than the company’s rate of profit, the return on the stocks will be higher. This phenomenon is known as financial leverage or capital leverage.

Therefore, financial leverage is an arrangement whereby fixed-yield securities (bonds and preferred shares) are used to raise cheaper funds and increase returns for equity shareholders. You may notice that a lever is used to lift something heavy by applying less force than is otherwise required.

Capital leverage denotes the relationship between various types of securities and total capitalization. The capitalization of a company is highly oriented when the share of capital stock in the total capitalization is small and it is poorly oriented when the capital structure dominates the capital structure.

Capital leverage is calculated by determining the relationship between the amount of equity capital (which represents securities with variable income) and the total number of securities (stocks, preferred shares, and bonds) issued by a company. Here is the capital structure of two different companies. Both companies have issued total securities worth Rs 20,000,000 and have equity shares worth Rs 5,00,000 and Rs 15,00,000 respectively. Company A is highly oriented since the ratio between share capital and total capitalization is small, that is, 25%. But in the case of company B, this ratio is 75%, so it is poorly targeted.

CAPITAL GEARING ANALYSIS

Company

(Rs.)

(a) Capital stock 5,00,000

(b) Obligations 15,00,000

(c) Total capitalization 20,00,000

(d) Capital Gearing (a / c × 100) = 5,00,000 / 2,00,000 × 100

= 25% (high gear)

The various securities issued must have such a relationship to the total capitalization that the capital structure is safe and economical.

Equity shares should be issued when there is uncertainty about earnings. Preferred shares, particularly cumulative ones, should be issued when average earnings are expected to be quite good. The bonds should be issued when the company expects significantly higher earnings in the future to pay interest to bondholders and increase returns to equity shareholders.

EQUITY NEGOTIATION

Stock trading is an arrangement whereby financial management raises funds by issuing securities that have a fixed interest rate (or dividend) that is less than the average earnings of the company. This is done to increase the return on equity stocks.

Suppose a company requires an investment of Rs. 10 Lakhs to earn Rs. 2.5 Lakhs @ 25% pa. To increase this amount, we can consider two proposals, namely, (A) to issue 1 lakhs of equity shares. Rs 10 each: and (B) to issue capital shares worth Rs 2.5 lakhs (i.e. 25,000 shares worth Rs 10 lakhs each), 8% preference shares worth Rs 2.5 lakhs and 10% bonds for value of Rs. 5 lakhs. The tax rate is assumed to be 40 percent. Earnings per share under proposal ‘B’ will be higher due to the application of ‘stock trading’. As shown in the table below, earnings per share (EPS) under Proposition B is Rs 4.00 compared to Rs 1.50 under Proposal A due to the use of debentures and preferred equity to raise funds.

EFFECT OF TRADING ON EQUITY

  • Individuals Proposal
  • Earnings before interest and taxes (EBIT) Rs 2.50,000
  • Less interest on obligations (10%) Nil
  • Earnings after interest and before taxes 2,50,000
  • Less taxes (40%) 1,00,000
  • Earnings after interest and taxes 1,50,000
  • Less preferred dividends (8%) Nile
  • Gain available to equity shareholders 1,50,000
  • No. of outstanding capital shares 1,00,000
  • Earning per share (EPS) Rs 1.50