Some of the factors that generally govern the capital gearing of a company are: 1. Trading on equity 2. Idea of retaining control 3. Elasticity of the capital structure 4. Needs of the potential investors 5. Capital market conditions 6. The cost of financing 7. The purpose of financing 8. Legal requirements 9. Period of finance 10. Nature of business and 11. Provision for future.
The term equity means the ‘stock’ or ownership of a company and trading refers to taking advantage of. Thus trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to the additional profits that equity shares earn because of issuing other forms of securities, viz., preference shares and debentures.
It is based on the theory that if the rate of interest on borrowed capital and the rate of dividend on preference capital which are fixed, is lower than the general rate of the company’s earning, the equity shareholders will get advantages in the form of additional profits.
Some important definitions are discussed below:
When a person or corporation uses borrowed capital as well as owned capital in the regular conduct of its business it is said to be trading on equity.”
“The use of borrowed funds or preferred stock for financing is known as trading on equity”.
—Guthmann and Dougall
“The degree to which debt is used in acquiring assets in called trading on equity.”
Trading on equity is an arrangement under which an enterprise uses borrowed funds carrying a fixed rate of interest in such a way as to increase the rate of return on the equity shares.
If a company can earn much more than the rate of fixed dividend or interest, excess earnings will go to the equity shareholders and they would thereby earn a higher dividend per share than they would have without the use of gearing of capital structure.
Suppose a company has a total investment of Rs. 10 lakhs and earns a profit at the rate of 10 per cent. If the entire capital has been raised by equity shares it cannot pay more than 10 per cent as dividend or more than Rs. one lakh, but if the company decides to trade on equity, it may raise funds in the following way:
(i) By issuing debentures carrying 6% interest Rs. 5 lakhs
(ii) By issuing preference shares carrying dividend @ 9% Rs. 2 lakhs
(iii) By issuing equity shares Rs. 3 lakhs
In this case the company will have to pay out of the profits of rupees one lakh earned by it, a sum of Rs. 30,000 as interest on debentures and Rs. 18,000 as dividend on preference shares. A sum of Rs. 52,000 will be left for paying dividend to the equity shareholders.
As the amount of equity capital is now only Rs. 3 lakhs, the dividend will carry the rate of 17.33 per cent. Thus, by issuing the debentures and preference shares, the rate of dividend to equity shareholders gets considerably increased. Also an indirect advantage accrues by saving of income tax, as interest paid on debentures is allowed as deduction in income-tax.
However, there are three limitations of trading on equity. Firstly, when the earnings of the company are not sufficient to pay fixed return on all types of securities, the dividend rate is unduly depressed rather than accelerated. Secondly, every successive borrowing has to be made at a higher rate of interest, with new lenders running a greater risk. In this way raising funds by borrowing becomes costlier and the benefit of the equity shareholder is reduced. Also, in order to indulge in large scale borrowing, a company must make huge investments in fixed assets which can be offered as security to the lenders. Lastly, trading on equity is profitable for a company which is likely to have regular, stable and certain earnings.
If the promoters want to retain effective control of the company, they may raise funds from the general public by the issue of debentures and preference shares. Debenture holders and preference shareholders are usually not given the voting rights enjoyed by the equity shareholders.
In India companies used to issue deferred shares carrying disproportionate voting rights to promoters and their relatives in order to monopolise control. However, this practice has been discontinued after coming into effect of the Companies Act, 1956.
Elasticity or flexibility is an essential sine qua non of an ideal capital plan. From this point of view the capital structure should be designed in such a way that both (i) expansion and (ii) contraction of capital may be possible.
It requires the fixed charges of the company should be kept well within its that earning capacity so that the new issues of capital may be easily saleable in future. Moreover, debentures should not be issued in the initial stage and be reserved for emergencies and expansion of the company.
An ideal capital plan is that which suits to the requirements of different types of investors. The investors who care more for the safety of principal and stability of income go in for debentures. The preference shares have got a good appeal for those investors who want a higher and stable income with enough safety of investment.
Ordinary shares are meant for those who want to take risk and participate in the management in order to have higher income as well as capital appreciation. The nominal value of the share should also be adjusted so as to secure subscription from the middle and lower classes of society.
The conditions prevailing in the money market also influence the determination of the securities to be issued. During periods of inflation, when people have plethora of funds, investors are ready to take risk and invest in equity shares.
But during depression or deflationary periods, people prefer debentures and preference shares which carry fixed rate of return. If therefore, a company wants to raise more funds it must carefully watch the market sentiments, otherwise it will not succeed in its plans.
The cost of raising finance by tapping various sources of finance should be estimated carefully to decide which of the alternatives is the cheapest. Interest, dividends, underwriting commission, brokerage, stamp duty, listing charges etc., constitute the cost of financing. Those securities which involve minimum costs should be preferred.
The corporation incurs the lowest expense in selling debentures and highest in raising equity capital. The financial structure therefore, should be judiciously diversified with suitable mix as to minimise the aggregate costs of financing.
The funds may be required either for betterment expenditure or for some productive purposes. The betterment expenditure may be done out of funds raised by share issue or still better out of retained earnings.
Funds required for expansion, purchase of new fixed assets etc., may be raised through debentures, if assets contribute to the earning capacity of the company.
Legal provisions regarding the issue of different securities should be followed, not all types of businesses may be subject to these legal provisions but for some these do apply. In India banking companies are not allowed by the Banking Companies Act to issue any type of securities except the equity shares.
When funds are required for permanent investment in a company equity shares should be issued. But when funds are required to finance expansion programme and the management of the company that it will be able to redeem the funds within the life time of the company, it may issue redeemable preference shares and debentures or obtain long-term loans.
Nature of business of the company also counts in determining the capital structure. Public utilities having assured market and freedom from competition and stability of income may find debentures as suitable medium of financing.
Manufacturing enterprises do not always enjoy these advantages, and therefore, they have to rely, to greater extent, on equity share capital. Service and merchandising enterprise having fewer fixed assets cannot afford to raise funds by long term debentures because of their inability to offer their assets in mortgage for the loans.
Financial planners always think of keeping their best security to the last instead of issuing all types of securities at one stretch.
Financial managers should have the readily marketable securities to be issued in times of contingencies. In the words of Gerstenberg, Managers of corporate financing operations must always think of rainy days of the emergencies. The general rule is to keep your best security or some of your best securities till the last. ”
During normal times equity shares should be issued. In times of emergencies debentures carrying fixed interest can be issued, if necessary, by creating charge on the assets of the company.
It can be concluded that ideal capital structure should be based on nature of the enterprise, the term of finance, stability of earnings, requirements of investors, trends in the market, phases of business cycle, the policy of limiting or enlarging the span of corporate control etc.