Top 17 Factors Determining the Capital Structure

This article throws light upon the top seventeen factors determining the capital structure. The factors are: 1. Financial Leverage 2. Growth and Stability of Sales 3. Cost of Capital 4. Risk 5. Cash Flow Ability to Service Debt 6. Nature and Size of a Firm 7. Control 8. Flexibility 9. Requirements of Investors 10. Capital Market Conditions 11. Assets Structure 12. Purpose of Financing 13. Period of Finance and Others.

Factor # 1. Financial Leverage:

The use of long-term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases magnifies the earnings per share if the firm yields a return higher than the cost of debt.

The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loans is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.

Factor # 2. Growth and Stability of Sales:

The capital structure of a firm is highly influenced by the growth and stability of its sales. If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payment and repayments of debt.

Similarly, the rate of growth in sales also affects the capital structure decision. Usually greater the rate of growth of sales, greater can be the use of debt in the financing of firm. On the other hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as far as possible, debt financing in its capital structure.

Factor # 3. Cost of Capital:

Every rupee invested in a firm has a cost. Cost of capital refers to the minimum return expected by its suppliers. The capital structure should provide for the minimum cost of capital. The main sources of finance for a firm are equity, preference share capital and debt capital.

The return expected by the suppliers of capital depends upon the risk they have to undertake.

Usually, debt is a cheaper source of finance compared to preference and equity capital due to:

(i) Fixed rate of interest on debt;

(ii) Legal obligation to pay interest;

(iii) Repayment of loan and priority in payment at the time of winding up of the company.

On the other hand, the rate of dividend is not fixed on equity capital. It is not a legal obligation to pay dividend and the equity shareholders undertake the highest risk as they cannot be paid back except at the winding up of the company and that too after paying all other obligations.

Preference capital is also cheaper than equity because of lesser risk involved and a fixed rate of dividend payable to preference shareholders. But debt is still a cheaper source of finance than even preference capital because of tax advantage due to deductibility of interest. While formulating a capital structure, an effort must be made to minimise the overall cost of capital.

Factor # 4. Risk:

There are two types of risk that are to be considered while planning the capital structure of a firm viz.:

(i) Business risk and

(ii) Financial risk.

Business risk refers to the variability of earnings before interest and taxes. Business risk can be internal as well as external. Internal risk is caused due to improper product mix, non-availability of raw materials, incompetence to face competition, absence of strategic management etc.

Internal risk is associated with the efficiency with which a firm conducts its operations within the broader environment thrust upon it. External business risk arises due to change in operating conditions caused by conditions thrust upon the firm which are beyond its control e.g., business cycles, governmental controls, changes in business laws, international market conditions etc.

Financial risk refers to the risk of a firm that may not be able to cover its fixed financial costs. Financial risk is associated with the capital structure of a company. A company with no debt financing has no financial risk. The extent of financial risk depends on the leverage of the firm’s capital structure.

When a firm uses more and more of debt in its capital mix the financial risk of the firm increases. It may not be able to pay the fixed interest charges to the suppliers of debt and they may force to liquidate. Thus, a firm has to reach a balance between the financial risk and the risk of non-employment of debt capital to increase its market value.

Factor # 5. Cash Flow Ability to Service Debt:

A firm which shall be able to generate larger and stable cash inflows can employ more debt in its capital structure as compared to the one which has unstable and lesser ability to generate cash inflows. Debt financing implies burden of fixed charge due to the fixed payment of interest and the principal.

Whenever a firm wants to raise additional funds, it should estimate, project its future cash inflows to ensure the coverage of fixed charges. Fixed Charges Coverage Ratio and Interest Coverage Ratio may be calculated for this purpose. 

Illustration 1:

A company is currently earning an EBIT of Rs. 712 lakhs . Its present borrowings are:

Capital Structure with Illustration 22

The sales of the company are growing and to support this the company proposes to obtain an additional bank borrowing of Rs. 25 lakhs. The increase in EBIT is expected to be 20%. Calculate the change in interest coverage ratio after the additional borrowing and comment.

Solution:

Solution

Comments:

By raising additional funds from bank borrowings, the interest coverage ratio falls from 1.045 to 0.93. The company may face difficulties in near times to pay even interest on loans and hence proposal is not sound.

Factor # 6. Nature and Size of a Firm:

Nature and size of a firm also influence its capital structure. All public utility concern has different capital structure as compared to other manufacturing concern. Public utility concerns may employ more of debt because of stability and regularity of their earnings.

On the other hand, a concern which cannot provide stable earnings due to the nature of its business will have to rely mainly on equity capital; similarly, small companies have to depend mainly upon owned capital as it is very difficult for them to raise long-term loans on reasonable terms and also cannot issue equity and preference shares at ease to the public.

Factor # 7. Control:

Whenever additional funds are required by a firm, the management of the firm wants to raise the funds without any loss of control over the firm. In case the funds are raised through the issue of equity shares, the control of the existing shareholders is diluted.

Hence, they might raise the additional funds by way of fixed interest bearing debt and preference share capital. Preference shareholders and debenture holders do not have the voting right.

Hence, from the point of view of control, debt financing is recommended. But, depending largely upon debt financing may create other problems, such as, too much restriction imposed upon by the lenders or suppliers of finance and ultimate bankruptcy of the firm due to heavy burden of interest and fixed charges. This may result into even a complete loss of control by way of liquidation of the company.

Factor # 8. Flexibility:

Capital structure of a firm should be flexible, i.e., it should be such as to be capable of being adjusted according to the needs of the changing conditions. It should be possible to raise additional funds, whenever the need be, without much of difficulty and delay.

A firm should arrange its capital structure in such a manner, that it can substitute one form of financing by another. Redeemable preference shares and convertible debentures may be preferred on account of flexibility. Preference shares and debentures which can be redeemed at the discretion of the firm offer the highest flexibility in the capital structure.

Factor # 9. Requirements of Investors:

The requirement of investors is another factor that influences the capital structure of a firm. It is necessary to meet the requirements of both institutional as well as private investors when debt financing is used. Investors are generally classified under three kinds, i.e., bold investors, cautious investors and less cautious investors.

Bold investors are willing to take all types of risk, are entreprising in nature, and prefer capital gains and control and hence equity share capital is best suited to them. Investors who are over-cautious and conservative prefer safety of investment and stability in returns and hence debentures would satisfy such overcautious investors.

Investors which are less cautious in approach will prefer preference share capital which provides stability in returns.

Factors Determining the Capital Structure

Factor # 10. Capital Market Conditions:

Capital market conditions do not remain the same forever. Sometimes there may be depression while at other times there may be boom in the market. The choice of the securities is also influenced by the market conditions.

If the share market is depressed and there are pessimistic business conditions, the company should not issue equity shares as investors would prefer safety. But in case there is boom period, it would be advisable to issue equity shares. Proper timing of issue of securities also saves in costs of raising funds.

Factor # 11. Assets Structure:

The liquidity and the composition of assets should also be kept in mind while selecting the capital structure. If fixed assets constitute a major portion of the total assets of the company, it may be possible for the company to raise more of long term debts.

Factor # 12. Purpose of Financing:

If funds are required for a productive purpose, debt financing is suitable and the company should issue debentures as interest can be paid out of the profits generated from the investment. However, if the funds are required for unproductive purpose or general development on permanent basis, we should prefer equity capital.

Factor # 13. Period of Finance:

The period for which the finances are required is also an important factor to be kept in mind while selecting an appropriate capital mix. If the finances are required for a limited period of, say, seven years, debentures should be preferred to shares.

Redeemable preference shares may also be used for a limited period finance, if found suitable otherwise. However, in case funds are needed on permanent basis, equity share capital is more appropriate.

Factor # 14. Costs of Floatation:

Although not very significant, yet costs of floatation of various kinds of securities should also be considered while raising funds. The cost of floating a debt is generally less than the cost of floating an equity and hence it may persuade the management to raise debt financing. The costs of floating as a percentage of total funds decrease with the increase in size of the issue.

Factor # 15. Personal Considerations:

The personal considerations and abilities of the management will have the final say on the capital structure of a firm. Managements which are experienced and are very enterprising do not hesitate to use more of debt in their financing as compared to the less experienced and conservative management.

Factor # 16. Corporate Tax Rate:

High rate of corporate taxes on profits compel the companies to prefer debt financing, because interest is allowed to be deducted while computing taxable profits. On the other hand, dividend on shares is not an allowable expense for that purpose.

Factor # 17. Legal Requirements:

The Government has also issued certain guidelines for the issue of shares and debentures. The legal restrictions are very significant as these lay down a framework within which capital structure decision has to be made.

For example, the controller of capital issues, now SEBI grants his consent for capital issue when:

(i) The debt-equity ratio does not exceed 2:1 (for capital intensive projects a higher debt- equity ratio may be allowed,

(ii) The ratio of preference capital to equity does not exceed 1:3 and

(iii) Promoters hold at least 25% of the equity capital.

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