Q4 Explain the factors affecting Capital Structure. Solve the below given problem: Given below are two firms, A and B, which are identical in all aspects except the degree of leverage, employed by them. What is the average cost of capital of both firms?
Q4 Explain the factors affecting Capital Structure. Solve the below given problem:
Given below are two firms, A and B, which are identical in all aspects except the degree of leverage, employed by them. What is the average cost of capital of both firms?
Details of Firms A and B
| Firm A | Firm B | |
| Net operating income EBIT | Rs. 1, 00, 000 | Rs. 1, 00, 000 |
| Interest on debentures I | Nil | Rs.25,000 |
| Equity earnings E | Rs.1,00,000 | Rs.75,000 |
| Cost of equity Ke | 15% | 15% |
| Cost of debentures Kd | 10% | 10% |
| Market value of equity S = E/Ke | Rs. 6, 66, 667 | Rs.5,00,000 |
| Market value of debt B | Nil | Rs.2,50,000 |
| Total value of firm V | Rs. 6, 66, 667 | Rs,7,50,000 |
Explanation of factors affecting capital structure
Solution for the problem
Interpretation
Answer: Factors Affecting Capital Structure
Leverage: The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans from banks and financial institutions, and debentures in the capital structure, is known as “trading on equity” or “financial leverage”. If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase without an increase in the owner’s investment. Similarly, the EPS will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because of the following reasons:
