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2. Risk Principle:
Risk depends upon variability in the firms’ operations. The
excessive use of debt magnifies the variability of
shareholders’ earnings and threatens the solvency of the
company.
3. Control Principle:
Capital structure should involve minimum risk of loss of
control of company.
4. Flexibility Principle:
Capital structure should be flexible. It should be possible
for company to adapt capital structure with minimum cost
and delay if required by a changed situation. Company can
fund its profitable activities whenever needed.
5. Timing Principle:
Capital structure should be feasible to implement given the
current and future conditions of capital market. It can
exploit the opportunities. The sequencing of sources of
financing is important. In periods of boom investors are
willing to part with funds and they can be attracted by
equity, during depress, steady interest income guaranteed
by debt finds many customers.
3. Stability of Earnings-
Greater stability of sale & earning allows a company to rely
on leverage principle and it can undertake fixed obligation
debt with low risk
Irregular earnings demand greater reliance on risk and,
therefore, equity.
4. Asset Structure of Company –
Assets consisting of long life fixed nature allow leverage and
use of cheap debt funds. But if assets consist of inventory and
debtors, risk principle over rides cost and favour common
stock.
5. Age of Company -Young companies are not known in
capital market & have to rely on common stocks for funds
and keep options open for future maneuverability. Mature
companies with good
earnings track record can raise funds from any source they
prefer and should use leverage fully.
6. Credit Standing - Strong standing allows company adjust
sources and retain flexibility. New companies with poor
credit standing have limited choices for sources of funds.
7. Attitude of Management -
Towards control and risk needs to be studied in deciding upon
pattern of capitalization. Their desire to retain control means
funds are to be sourced from debt instruments. Directors who
are at the helm of control for long period would like to leverage
their funds.
Leverage
Leverage (Advantage): The ability to influence a system, or an
environment, in a way that multiplies the outcome of one’s
efforts without a corresponding increase in the consumption of
resources.
Two types of Leverage: 1) Financial Leverage and 2)
Operating Leverage
1) Financial Leverage: The use of the fixed-charges sources
of funds, such as debt and preference capital along with the
owners’ equity in the capital structure, is described as
financial leverage or gearing or trading on equity.
Trading on Equity means using the owners’ equity as a
basis to raise debt.
Measurement of Financial Leverage
a) Debt ratio: debt by total capital; Debt/ Debt+Equity
b) Debt-equity Ratio: Debt by equity; Debt/Equity
c) Interest Coverage: EBIT/Interest
DEBT ratio and Debt-equity ratio both rank rank
companies in the same order, as there is no difference
between both measures in operational terms.
Debt-equity ratio is more popular in practices.