MGT201 Module 11 Topics 200-216 Preparation

Topic 200: Capital Structure-Introduction

Capital Structure:

In simple words, Capital Structure shows that what is the percentage of debt and equity in any business or company. It means that Capital Structure actually comprises of debt (I.e., loan, bonds etc.) or equity (I.e., common stocks, preferred stocks) or a combination of these three things is called Capital Structure.

Mix of Debt and Equity: If the percentage of equity becomes increased and percentage of debt or preferred stock also varies then we can say that Capital Structure gets changed. So, a given Capital Structure simply means that there is a fixed percentage of debt and equity in this business.

Financial Leverage: With reference to Capital Structure, the interesting concept which actually affects the Capital Structure is Financial Leverage. The Financial Leverage simply determines the percentage of debt in the total capital meaning that if we have capital of 100 million then how much is the debt in that capital. Let’s say if the debt is 40 million so, the leverage is 40%.

The basic thing that we need to understand here is that as the financial leverage get increase, the return of shareholder or equity holders also get increased. So, when we are changing the Capital Structure by increasing the financial leverage and reducing the percentage of equity, the return to the equity holders increases or we can say that it should increase.

What does this financial leverage do?

When we borrow money through banks or bonds or take debt then it creates Financial Leverage. Suppose we have borrowed money as a business or company at the rate of 10% and invested that borrowed amount in our business and have earned 15% profit or return per year from that borrowed amount and after giving the 10% to the bond holders/investors/loan providers from the earned 15% return or profit, we have left with 5% additional profit which will be added into our shareholders or equity holders’ profit.

The return of shareholders or equity holders will not be 15% but it will increase to 20% and this is the impact of Financial Leverage.

This picture also depicts that with the lesser amount of investment, we get greater return and this is the job of lever meaning that lever is such an invention through which we can put up more weight by applying less force. So, Financial Leverage actually refers to that with a smaller amount that we get higher return.

Components of Capital Structure:

Common share capital: This is one part of the Capital Structure in which the financial leverage would affect as a positive return.

Preferred share capital: Then there are preferred shareholders, they are not directly affected by financial leverage generated to the bonds but one view point is that preferred shares because of the fixed cost also create a financial leverage in a company.

Loan: This is also part of Capital Structure.

Bonds: This is also part of Capital Structure.

So, we can say that in this Capital Structure (in which there are common shares, preferred shares, public and private debts etc.), and financial leverage creates from where. We can conclude our discussion that Financial Leverage mainly is generated by loan, bonds and other debts but the fixed cost of preferred share capital also creates a financial leverage. And when we say that there happening changes in the Capital Structure then actually the percentage of financial leverage is increasing or decreasing and mainly this leverage is due to the debt.

Topic 201: Goals of a Firm

In this lecture, we will talk about the goals or the objects of a firm or a business or a company or any entity which is a commercial entity.

Profit Maximization:

The basic objective is certainly Profit Maximization. Every business that is established for the reason to earn profit from it, it is a commercial business then its prime objective is to maximize the profit and the term that we use is Profit Maximization. So, the prime objective of any business from the perspective of management is that to maximize its profit.

Maximization of Wealth:

If we have started our business with Rs.100 and earn profit of Rs.10 after one year then our profit of Rs.10 will be added in our wealth and in this way, our overall wealth becomes from Rs.100 to Rs.110. So, looking at the concept of Maximization of Profit and Maximization of Wealth seems to be very similar but the slight difference is that when we talk about the Maximization of Wealth, it is an absolute term meaning that how much amount of investment has been increased in rupees or dollars and we try to increase more and more in commercial ventures and that is called Maximization of Wealth.

Maximization of profit means that how much maximum percentage of profit we want to earn from our investment and we can say that if there will be more profit