Question

Q7: How can a firm’s financial leverage boost its return to common shareholders (ROE)? Use an example to explain it.

Q10: How to estimate a firm’s optimal capital structure?

Answer 1

Answer 7 : A firm’s financial leverage boost its return to common shareholders (ROE) :-

Introductive : A Company needs funds to manage its business. Most of companies, financial capital Structure is collected by debt securities issuance and the selling of common stock which has many consequences for risk and return. Corporate management therefore needs to use rigorous and prudent method to create a target capital structure for thier organization. The capital structure is in short of how a fiem uses different sources of funds to finance its operations and development.

Empirical Use of Financial Leverage :

The Degree to which fixed income securities and prefereed stock are included in the capital strucure of an company is financial leverage. Financial debt has value because of the interest tax protection offered by corporate income tax laws.The use of financial leverage also has meaning when the assets gained with the debt capital gain more than the debt expense used to funded them.

Under these two circumstances, the use of financial leverage increases profits for the company. One can say that, if the company does not have enough taxable income to cover, or if its operating profits are below a critical amount, the financial debt would decrease the equity value and therefore decrease the company's value.

Given the importance of a company’s capital structure, the first step in the capital decision-making process is for the management of a company to decide how much external capital it will need to raise to operate its business. Once this amount is determined, management needs to examine the financial markets to determine the terms in which the company can raise capital. This step is crucial to the process because the market environment may curtail the ability of the company to issue debt securities or common stock at an attractive level or cost. Once these questions have been answered, the management of a company can design the appropriate capital structure policy and construct a package of financial instruments that need to be sold to investors. By following this systematic process, management’s financing decision should be implemented according to its long-run strategic plan, and how it wants to grow the company over time.

The uses of the financial leverage varies greatly from company to sector. There are several areas of business where businesses work with a high degree of financial leverage. For Example, various retails stores, grocerry stores, utilities companies, banking sectors and Airlines Sector.

Impact of Financial Leverage on Performance :

While Making best way to evaluate the positive effect of the financial leverage on the financial performance of a company is by giving a simple example.
The Return on Equity (ROE) is popular basic used to measure a business' profitability, as it compares the profit a company generates with the money shareholders invested in a fiscal year. Afterall, the goal of every business is to maximize shareholder wealth, and the ROE is the metric of the return on invested by the shareholder.

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Answer 10 : To estimate a firm’s optimal capital structure :-

The importance of optimal capital structure for determining optimum capital structure is first questions towards finding them as optimal. In Simple terms, "Optimal capital structure is the point at which our capital costs and business risk are minimal."

"A firm's ideal capital structure is the best mix of debt and equity funding that maximizes the market value of a
company while reducing its capital cost." In principle, debt financing owes its tax deductibility to the lowest cost of
capital. But too much debt increases shareholders' financial risk and the return on equity they require.

Thus, businesses must find the optimal point at which the marginal benefit of debt is equal to the marginal cost.

So, for estimating optimal capital structure, we have to follow step by steps :
1st Step : Find Different Capital Structure with Debt Equity Ratio
Capital structure is the mixture of capital as well as debt.
For example, we can take Rs.100,000 capital and Rs. 0 debt or
we can take Rs. 95000 capital through shares and Rs. 5000 debt through issue of debenture.
  Total capitalization value will be same in each n every case.
For easy understanding the capital structure, we will calculate debt equity ratio. Debt/equity will be debt equity ratio.
For example Rs.100,000 capital and Rs. 0 debt will be 0/100 debt equity. Rs. 95000 capital through shares and Rs. 5000 debt will be 5/95 as debt equity ratio.

2nd Step : Find the Cost of Capital and Cost of Debt at Different Level of Capital Structure
Cost of capital is dividend rate and cost of debt is interest on loan rate. If there is lowest risk, both cost of capital and cost of debt will low.
For example if debt equity ratio is 5/95, it means we have Rs. 95 capital for repaying Rs. 5 loan, this lowest risky capital structure, so, cost of capital will be 10% and cost of debt will be 4%. But when the risk of repayment of loan will increase due to increasing debt resource and decreasing capital resource, both cost of capital and cost of debt will increase. If debt equity ratio will be 90/10, its is one of highest risky capital structure in which we have just Rs. 10 capital for repaying Rs. 90 loan, so both capital and debt will become default because it is the basic rule when company will become insolvent, we use all the capital for repaying secured loan. So, Rs. 10 capital will become zero. and Rest Rs. 80 loan become zero. So, cost of capital will increase upto 16% and cost of debt will increase upto 8%.
So, Calculate all the cost of capital and cost of debt on different capital structure.

3rd Step : Find the Weighted Average Cost of Capital
If we take the average of cost of debt and cost of capital, it will become average cost of capital. But weighted average cost of capital will give more suitable result.
So, we will calculate WACC which is also average cost of capital but we take the product of cost of capital and debt equity ratio. For example, debt equity ratio is 10/90, and cost of capital 10% and cost of debt is 4%, then WACC will be (0.10 X 4%) + ( 0.90 X 10%) = 9.4%

4th Step : Reach Optimal Level of Capital Structure
After analysing, cost of capital, cost of debt and weighted average cost of capital and debt equity ratio , we can reach optimal level of capital structure. It is the point of debt equity ratio where is the weighted average cost of capital will be minimum.

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