Capital structure represents the proportion in which various long-term capital components are employed. The capital decisions have been recognized as the most important decisions affecting the successful working of any firm. This is due to the fact that the capital structure affects the cost of capital, net profit, earnings per share, dividends payout ratio and liquidity position of the firm. These variables coupled with a number of other factors determine the value of a firm. Therefore capital structure is a very important determinant of the value of a firm.
There are different forms of financial securities offered by a company in order to secure the required funds from the investors. The most common method of raising long term finance is the issue of common stock. The common stocks of a corporation do not carry any special rights in terms of payment of dividend as compared to preferred stock. Preferred stocks carry a specific percentage of return on the investments by the preferred stock holders. In addition the preferred stock holders stand in priority to the common stock holders in getting a distribution of the assets of a corporation in the event of its winding up. In some instances the preferred stock holders also carry special voting rights as distinguished from the common stock holders.
Convertible securities are bonds or preferred stocks that are convertible into a specified number of shares of common stock at the option of the stock holder. This is yet another of form financial security being offered by the corporations to secure the long term investment of the stock holders. The convertible security provides the convertible holder a fixed return in the form of interest or dividend and also the option to exchange a bond or preferred stock for common stock.
Warrants and derivatives are a relatively long term option to purchase common stock at a specified exercise price over a specified period of time. Warrants are used to obtain a lower interest rate and to raise funds when the firm is considered as having a marginal credit risk. Warrants are also issued to compensate the underwriters and venture capitalists at the time of founding a company in return for their services or as commission payable to them. (Chapter 22)
Bailey Corporation Case
a) Number of Shares Outstanding 1,800,000
New shares Issued 800,000
Total Number of Shares 2,600,000
Retained Earnings $ 7,580,000
Earnings per Share after the Offering $ 2.92
Assumed price earnings 12
Initial Price per share 12 * 2.92 $ 35.04
b) Total proceeds 800,000 * $ 35.04 $ 28,032,000
Less: Underwriting spread @ 5% $ 1,401,600
Less: Out of Pocket Expenses 300,000
Total Cost $ 1,701,600
Net Proceeds $ 26,330,400
c) Current Earnings $ 7,580,000
Number of original outstanding stock 1,800,000
EPS on original stock outstanding $ 4.21
Return needed for achieving