Everything you need to know about the factors affecting capital structure decisions of a company. The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to fund its long-term asset.
The key division in capital structure is between debt and equity, the proportion of debt funding is measured by gearing or leverages. There are different factors that affect a firm’s capital structure, and a firm should attempt to determine what its optimal, or best, mix of financing.
The following factors must be kept in mind while taking capital structure decisions are:-
1. Size of Business 2. Form of Business Organisations 3. Stability of Earnings 4. Degree of Competition 5. Stage of Life Cycle 6. Credit Standing 7. Corporation Tax 8. State Regulations
9. State of Capital Market 10. Attitude of Management 11. Trading on Equity 12. Interest Coverage Ratio 13. Cash Flow Ability of the Company 14. Cost of Capital 15. Flotation Costs
16. Control 17. Flexibility 18. Leverage Ratios for Other Firms in the Industry 19. Consultation with Investment Bankers and Lenders 20. General Level of Business Activity 21. Marketability and Timing of Shares 22. Profitability 23. Nature of Business of Firm
24. Legal Requirements 25. Tax Benefits 26. Growth Prospects 27. Floatation and Other Costs 28. Asset Structure 29. Risk Appetite of Management 30. Degree of Competition 31. Economic Conditions 32. Government Policies.
Factors Affecting Capital Structure of a Company: 32 Factors
Factors Affecting Capital Structure – Size of Business, Form of Business Organisations, Stability of Earnings, Degree of Competition, Stage of Life Cycle and a Few Others
Initially, at the time of promotion of company, capital structure plan is to be prepared very carefully. First of all, the objective of the capital structure should be determined and then the financing decisions should be taken accordingly. Company has to arrange for funds for its activities continuously.
Every time when the funds are to be procured, financial manager has to choose the most profitable source of finance after considering the merits and demerits of different sources of finance. Therefore, capital structure decisions have to be taken on continuous basis.
Following factors must be kept in mind while taking capital structure decisions:
Factor # 1. Size of Business:
Small businesses have to face great difficulty in raising long-term finance. If, it is at all able to get long-term loan, it has to accept unreasonable conditions and has high rate of interest. Such restrictive conditions make the capital structure inflexible for small companies and management cannot freely run the business.
Therefore, small businesses rely on share capital and retained earnings to meet their requirements of long-term funds. Small companies have to bear greater cost of raising long-term funds as compared to large companies. Besides, issuing ordinary shares every time to raise long-term funds may result in loss of control by existing shareholders.
The shares of a small company are not widely held and the dissatisfied class of shareholders can easily organise to keep the control in their hands. Therefore, small companies do not allow to expand their business much and manage their funds out of retained earnings. Large companies are able to raise their long-term loans at comparatively cheaper terms and can issue ordinary shares and preference shares to the public.
Due to issuance of shares of high amount, the cost of issue is low in comparison to small companies. Therefore, while preparing capital structure plan, company should make proper use of its size.
Factor # 2. Form of Business Organisations:
‘Control’ is much significant in case of private companies, sole traders and partnership firms because in such businesses, ownership is limited to a few hands. In public limited companies, ownership is widely spread. Therefore, control can’t be restricted.
Factor # 3. Stability of Earnings:
The sale and stability of income affects the quantum of leverage. The companies which have stability in income and sales, can use more amount of debt in their capital structure. They can easily pay their fixed financial charges. The industries producing consumer goods face more fluctuations in their sales and, therefore, use lesser amount of debt.
On the other hand, income and sales of public utility institutions are more stable and therefore, they can use more debts in financing their assets. Expected increase in sales also affects the amount of leverage. This is the reason that developing companies use more debt in their capital structure.
The companies whose sales are decreasing, should not use debt or preference share capital because they can face difficulty in the payment of interest and preference dividend, as a result of which the company could be liquidated.
Factor # 4. Degree of Competition:
If in an industry, the degree for competition is high, such companies in that industry should use greater degree of share capital as compared to the debt capital. On the other hand, the industries in which the degree of competition is not so high, have a tendency of stable income and, therefore, they can use more debt.
Factor # 5. Stage of Life Cycle:
Stage of the life cycle of a firm is also an important factor affecting the capital structure. If a firm is in its initial stages, there are more chances of its failure. In such case, the use of ordinary share capital should be emphasised. Firm can work properly if it does not issue such securities on which it has to pay fixed amount of interest.
In such case, the risk is high. When a firm is passing through the stage of growth, it should plan its capital structure in a manner that it can raise finance easily whenever it needs. When a firm enters the stage of maturity, it has to spend more on the development of new products and, therefore, funds should be raised from ordinary shares because there is uncertainty in the increase in income of business.
If in the long-run, there is possibility of reduction in level of business activities, the plan of capital structure should be prepared in a manner so as to facilitate the repayment of surplus funds.
Factor # 6. Credit Standing:
The companies whose credit standing is better from the viewpoint of investors and creditors, are able to raise funds on convenient terms. But in case the credit standing is not good, the financing decision becomes limited.
Factor # 7. Corporation Tax:
Due to the current provisions of tax, the use of debt in the capital structure is cheaper as compared to the ordinary share capital or preference share capital. Interest is chargeable expense from the taxable income, whereas dividend is paid out of earnings available after tax. Hence, level of tax affects the cost of capital.
Therefore, to take the advantages of trading on equity, management uses more loan capital in the capital structure which helps in increasing the income of the shareholders. From Table 1 it is clear that by use of 6% debentures, the profit available for equity shareholders is Rs.33,000 and by using 6% preferred stock, this income is only Rs.6000. Thus, ordinary shareholders have an additional income of Rs.27,000 (Rs.33,000- Rs.6,000) due to income tax.
In the same manner, if the shareholders come under high income tax bracket, the company meets its financial requirements by retaining a major part of its income. On the other hand, if the shareholders fall in low income tax bracket, they will like to get high dividend and in such case the company will meet its financial requirements from external sources.
Factor # 8. State Regulations:
Capital structure decisions of the company are also affected by the government regulations. In India, Capital Issues Control Act determined Debt-Equity Ratio for the companies. Similarly, maximum rate of interest on debenture was also fixed up to May 1992. Directions and guidelines have also been issued for issuing the bonus shares. Management should consider these regulations while planning the capital structure. Now after May 1992, Capital Issues are controlled by SEBI.
Factor # 9. State of Capital Market:
While taking decision on the capital structure, tendencies of the capital market should be taken into account because these affect the cost of capital and availability of funds from different sources. Sometimes, company wants to issue ordinary shares but the investors do not want to invest in that company due to high risk.
In such a situation, company should not issue shares and necessary funds should be raised from other sources. Therefore, timing of the issuance of securities to the public is an important factor affecting the capital structure of a company. Government monetary and taxation policies are also significant in this regard.
If the management feels that debt funds will become costlier in future, it should raise necessary funds from the debt sources soon. If the rate of interest is expected to be lower, management can raise funds from other sources and can take the advantage of lower interest rate in future.
Factor # 10. Attitude of Management:
The attitude of management towards the factors affecting the capital structure also affects the capital structure. The attitude of management towards risk and control should be analysed. Some managers do not want to bear much risk. In such case, ordinary share capital should be used in place of debt funds. The manager who wants to take much risk, can make use of more and more loans.
Factor # 11. Trading on Equity:
To arrange funds for acquiring company’s assets, the use of fixed cost sources like debt and preference share capital is called trading on equity or financial leverage. If the return on assets acquired from the debt funds is greater than the cost of debt, the earnings per share will increase.
The income will also increase by the use of preference share capital but it will increase more by the use of debt funds because interest is allowed as an expense from the taxable income. Because of its effect on the earnings per share, financial leverage is an important factor in planning the capital structure.
The greater the earnings per share (EPS), more profitable it will be for the ordinary shareholders. To calculate the effect of leverage on EPS and earnings before interest and taxes (EBIT), analysis must be made by the management among the alternative sources of funds. If the interest and earnings before tax are increasing, EPS will increase by the use of more debt. Therefore, a company should use such sources of finance which lead to the maximisation of EPS.
A firm has an all equity capital structure consisting of 50,000 ordinary shares of Rs.10 each. The company wants to raise Rs.1,25,000 to finance its investments and is considering three alternative methods of financing – (i) to issue 12,500 ordinary shares of Rs.10 each, (ii) to borrow Rs.1,25,000 at 8% rate of interest, (iii) to issue 1250 preference shares of Rs.100 each at 8% rate of preference dividend. If the firm’s earnings before interest and taxes after additional investment are Rs.1,56,250 and tax rate is 50%, calculate the effect on the earnings per share under the three financing alternatives.
From the above example, it is clear that EPS can be maximised by the use of debt. When rate of interest on debt is more than the rate of return on investment, debt financing should not be used because it will reduce the Earnings Per Share (EPS).
Factor # 12. Interest Coverage Ratio:
By the use of this ratio, it can be ascertained whether the company has the capacity to pay interest or not. The greater this ratio, more will be the capacity of the company to use debt.
The ratio can be calculated as under:
Interest Coverage Ratio = Earnings before Interest and Taxes / Interest
Factor # 13. Cash Flow Ability of the Company:
Sometimes, the interest coverage ratio of a company is high but it does not have adequate cash to pay interest or preference dividend. Due to this reason, company can be financially insolvent. Therefore, a company must have so much cash balance that it can pay its fixed charges in time.
The amount of fixed charges will be greater if a company uses more debt financing or preference share capital. Higher the efficiency of cash flow, more will be its ability to use debt funds. Therefore, whenever a company thinks of using additional debt, it must analyse its capacity of generating cash flows to pay the fixed charges.
The companies which foresee higher possibility of more and stable cash inflows in future, can use more debt in their capital structure. The capacity of the firm to pay fixed charges and generate cash flows can be determined by calculating the ratio of net cash inflows to fixed charges. The greater this ratio, the higher will be debt capacity of the firm.
Factor # 14. Cost of Capital:
The cost of a source of finance is the minimum rate of return expected by its suppliers. The expected rate will depend upon the risk borne by the investors. Ordinary shareholders bear the maximum risk because no rate of dividend is fixed for them and the dividend is paid after the payment of interest and preference dividend.
The payment of interest on debentures is a statutory liability of the company whether the company earns profits or not. Therefore, debt is cheaper as compared to ordinary share capital. Cost of debt becomes lesser because interest is a charge on the taxable income.
But it should be kept in mind that debt can be cheaper only upto a particular point and the company cannot always decrease the overall cost of capital by using debt. Later, debt can be costly because use of more debt raises the risk for both the creditors and the shareholders.
When the quantum of risk increases, creditors are not ready to provide loans. If at all they agree, they demand higher rate of interest. Similarly, ordinary shareholders also expect higher dividend due to the use of more debt finance and thus, cost of share capital increases. All this decreases the market price of the shares.
If share capital and retained earnings are compared, the cost of retained earnings will be lower because, on the one hand, it has no issue expenses and on the other, shareholders will not have to pay personal income tax on the retained earnings which otherwise was payable on dividends.
Factor # 15. Flotation Costs:
These costs are incurred at the time of issue of securities. These costs include commission, brokerage, stationery and other expenses. Normally the cost of debt is less than cost of issuing shares. Therefore, the company can be attracted towards the loan funds. In case of retained earnings, no such issue expenses need to be incurred.
But flotation costs are not the most important factor in capital structure decisions. If the amount of issue is increased, the percentage of flotation costs can decrease.
Factor # 16. Control:
In present times, management wants to maintain its existence continuously and does not want any outside interference. Ordinary shareholders have got legal right to appoint directors. If the company is paying interest and instalment of loan in time, the creditors of company can’t interfere in managerial decisions.
Similarly, preference shareholders do not have voting right. But in case the company is unable to pay dividend to the preference shareholders for certain period of time, the preference shareholders get a right to participate in the meetings of the company. Thus, in most of the circumstances, ordinary shareholders have the right to appoint directors.
If the main objective of the management is to keep control in the existing hands, it will raise additional finance from debt and preference shares because it will not adversely affect its control. But if company takes loan more than its capacity and is unable to pay interest and principal amount in time, creditors can take the control of company in their hands and the control of company can be taken away from the present management.
In such case, issue of ordinary shares would be fair. In closely held company, the element of control becomes more significant. A shareholder or a class of shareholders can take the control of the company in its hands by buying all or almost all the shares of fresh issue. Therefore, these companies issue debt capital or preference share capital to avoid the risk of loss of control.
If these companies are able to widely spread the issue, there is no risk of loss of control. In case of widely held companies, there is no risk of loss of control by issuing new shares because their shareholders are widely spread. Most of the shareholders have interest in the returns; they do not have time to participate in the meetings of the company.
Factor # 17. Flexibility:
The managerial ability to make adjustment (increase or decrease) in the sources of finance at the time of change in needs of funds is called flexibility. Capital structure of a company is called flexible when it does not face any difficulty to change its capitalisation or the sources of finance.
Therefore, the management should take into account the future effects on the present capital structure. Whenever a company needs finance for profitable investment, it must be able to raise necessary funds without delay and at reasonable cost. If less funds are required, company must be in a position to redeem the debentures and preference share capital.
Flexibility in the capital structure depends on following:
(i) Flexibility in fixed expenses
(ii) Restrictive conditions in the debt agreement
(iii) Terms of Redemption
(iv) Debt Capacity.
The interest on loans and dividend on preference shares are of fixed nature but it is not necessary to pay dividend on ordinary shares. To reduce the burden of fixed expenses, it will be good to issue ordinary shares but it will not be able to take the advantage of financial leverage.
Sometimes, restrictive conditions are imposed on the company at the time of issue of debentures or taking long-term loans from financial institutions. It reduces flexibility of management in financial affairs. Therefore, while planning the capital structure, it should be noticed that minimum restrictive conditions are imposed.
If a company has the option to redeem its debentures or preference shares, management can substitute one source with the other and repay the surplus funds to raise profitability. Therefore, a company should not raise its debt capital fully because firm will not be able to raise any loan in future at the time of need.
Because of high risk, ordinary share capital will also be available at high cost. Therefore, considering the risk and to maintain flexibility management should not fully utilise the debt capacity.
Factor # 18. Leverage Ratios for Other Firms in the Industry:
While taking capital structure decisions, debt-equity ratio of other firms in the industry should be compared. Debt-equity ratio of the industry acts as a standard. If the debt-equity ratio of the firm is not similar to the debt-equity ratio of the industry, its reasons should be ascertained.
Factor # 19. Consultation with Investment Bankers and Lenders:
In order to determine the proportion of various securities in the capital structure, investment bankers and lenders should be consulted. These analysts have knowledge about the securities of large companies and know how the capital market evaluates them. They can give proper advice about the capital structure.
Similarly, the financial manager must also seek the opinion of prospective lenders and investors because they have to provide funds to the company. From it the company can know in what type of securities they want to invest and accordingly financial manager can take decision to include these securities in the capital structure.
Factor # 20. General Level of Business Activity:
If an economy is recovering from depression, the business activities in the country will expand. The possibilities of development of business will increase due to it. As a result, company may require additional funds in future. In such cases, management should give more importance to the flexibility of capital structure so that it may be able to raise funds from alternate sources to meet its needs. The company, in such situation, should issue ordinary share capital rather than debt.
From the above it is clear that various factors affect the capital structure. Some of them are self-contradictory. For example- from the view point of cost of capital, a company should use more debt because it is cheaper source as compared to others. But use of more debt increases financial risk and flexibility for management comes down.
From the viewpoint of flexibility, firm should use more ordinary share capital. Therefore, a financial manger should take capital structure decision by establishing a proper balance among all these factors.
Factors Affecting Capital Structure Decisions – General Factors to Consider in Order to Frame a Capital Structure Decision
Capital structure decision is a continuous one and has to be taken whenever the firm needs additional finance.
But the following are the general factors considered, in order to frame a capital structure decision:
1. Leverage or trading on equity, effect on earnings per share.
2. Growth and stability of sales.
3. Cost of capital.
4. Cash flow capacity of the firm.
7. Size of the firm.
8. Marketability and timing of shares.
9. Flotation costs, and
A Firm can make use of different sources financing whose costs are different. The sources of fund which carry a fixed rate of return (that is, preference capital and debentures), and those on which the returns vary (that is, equity shares). The fixed return funds have implications for those who are entitled to a variable return.
In other words, the fixed return source of funds, involves the payment of a stated amount. The return to the equity shareholders is affected by the magnitude of fixed source of funds in the capital structure of the firm.
The use of the fixed charge sources of funds (that is, debentures and preference capital) along with equity capital in the capital structure is described as financial leverage or trading on equity. The use of the term “trading on equity” is derived from the fact that, it is the owner’s equity that is used as a basis to raise debt, that is, the equity that is traded upon.
The debt funds carry a fixed rate of interest or dividend, which is a contractual obligation for the firm. Although the dividend on preference shares is not a contractual obligation, it is a fixed charge and must be paid before any dividend is paid to the equity shareholders. The equity shareholders are entitled to the remainder of the operating profits of the firm after the fixed charges are met.
Financial leverage results from the presence of fixed charges in the firm’s income stream. These fixed charges do not vary with the operating profits. They have to be paid regardless of the amount of operating profits. Financial leverage is concerned with the effects of changes in EBIT, on the earnings available to equity shareholders.
It can be defined as the, “ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the firm’s earnings per share.” In simple terms, financial leverage involves the use of fixed cost sources of funds in the capital structure of the firm, in order to maximise the returns to the equity shareholders.
The surplus (or deficit) from this operation, will increase (or decrease) with the returns available for the equity shareholders. For example- if a company borrow Rs. 10,00,000 at 16 percent interest and it earns 20 percent out of that investment, then the profit for equity shareholders is four percent and that is the profit from financial leverage.
But if the firm earned only 12 percent from that investment, then the loss to the equity shareholders would be four percent per annum. Thus, financial leverage is a double edged sword, because it can increase the earnings for equity shareholders, as well as create risks of loss to them.
Using debt in the capital structure is more advantages for financial leverage, due to the following reasons:
a. The cost of debt is usually lower than the cost of preference share capital, and
b. The interest paid on debt is tax deductible.
Favorable or positive financial leverage occurs, when the firm earns more on the assets purchased with the funds, than the fixed cost, or vice versa. The difference between the earnings from the assets and the fixed cost on the use of the funds goes to the equity shareholders. Thus the use of fixed cost of funds provides increased return for equity shareholders, without additional funds from the shareholders. Equity is thus traded in this operation and that is why financial leverage is rightly described as trading on equity.
This will operate in the opposite direction when earnings are not adequate to meet the fixed costs. So the trading on equity is also referred to as a double edged sword. Due to the effect on EPS, financial leverage in an important factor to be considered while planning the capital structure of a firm.
As already explained, EPS rises and falls faster than the rise and fall in EBIT, by the use of fixed cost funds. Thus financial leverage not only magnifies EPS, but also increases its variability.
Two types of risks is attached to variabilities of EBIT and EPS, i.e.:
a. Operating risk, business or trade risk, and
b. Financial risk.
According to professor Marshall, the distinction between operating and financial risk can be explained with the help of the following example. Let us assume that Amith and Ashok are carrying on textile business. Amith is using his own funds and Ashok is using borrowed funds. There is one set of risk common to Ashok and Amith, that is, operating risk, or trade risk, that is the risk of the textile business in which they are engaged.
a. Operating Risk:
Operating risk can be defined as “the variability of EBIT, (or return on total assets) due to internal and external factors”.
The variability of EBIT is due to two reasons:
i. Change in sales, and
ii. Change in expenses.
Sales may fluctuate due to three reasons, i.e.:
(i) Changes in general economic conditions – For example- changes in government policies, boom, depression, policy changes by the Reserve Bank of India, etc.
(ii) Specific events or factors affecting sales belonging to a particular industry, that is, availability of raw materials, technological changes, policies of competitors, changes in industrial relations, shifts in consumer preferences, etc.
(iii) Due to internal factors of the firm, that is, change of management, strikes, lockouts, product diversification, etc.
EBIT is also affected due to changes in fixed, variable and semi variable expenses. If the firm is in a position to control these expenses, EBIT will definitely increase.
The variability of EPS caused by the use of financial leverage is called financial risk. Two firms exposed to the same degree of operating risk can differ with respect to financial risk, when they finance their assets differently, that is, using own funds and borrowed funds. A totally equity financed firm will have no financial risk. But when debt is used for financial planning, the firm adds financial risk. Financial risk is thus an avoidable risk, if the firm decides not to use any debt in its capital structure.
Another important factor to be considered while framing the capital structure of a firm is the growth and stability of sales, because EBIT – EPS will fluctuate with fluctuations in sales. The firms with stable sales will have stable operating profit and EPS, so they can employ a high degree of leverage, because they will not face difficulty in meeting their -fixed commitments.
The likely fluctuations in sales increase the business risk. Sales of consumer goods industries show wide fluctuations, therefore, it is advisable that they should not use large amount debt in the financial planning. But sales of public utilities are quite stable and predictable, therefore they can use large amount of debt to finance their assets.
Moreover, there are no credit sales for public utilities, so they can calculate the available funds accurately. However growth firms and companies with declining sales should not use debt in the capital structure, because nonpayment of fixed charges can force a company into liquidation.
An important element in evaluating capital expenditure decisions is a certain discount rate or required rate of return. This rate is used in all discounted cash flow methods, to evaluate investment projects. In the present value method of discounted cash flow technique, the cost of capital is used as the discount rate to calculate Net Present Value (NPV). When Internal Rate of Return (IRR) method is used, the computed IRR is compared with the cost of capital.
The cost of capital thus constitutes an integral part of investment decisions. It provides a yardstick to measure the worth of investment proposals and thus can be used to decide, accept or reject criterion. It is also referred to as cut off rate, target rate, hurdle rate, minimum required rate of return, standard return, etc.
As per accept or reject criterion, a firm should accept only such investment opportunities that offer a rate of return higher than the cost of capital, that will in turn maximise the wealth of the equity shareholders. On the other hand, the shareholders wealth will decline, if a proposal is accepted in which the actual return is less than the cost of capital. Thus the cost of capital provides a rational mechanism for making the optimum investment decisions, that is, to decide the accept or reject criterion.
A firm is considered prudently financed, if it is able to service its fixed charges, (debenture interest, preference dividend and terms and conditions of repayment) under any circumstances. The amount of fixed charges will be high, if the firm employs a large amount of debt or preference capital with short term maturity. Moreover as per the Securities and Exchange Board of India regulations, debentures and preference capital are to be redeemed in ten years.
Therefore, whenever a company thinks of raising additional capital, it should analyse its expected future cash flows to meet the fixed charges, if not, the company may have to face financial insolvency. Thus the company expecting larger and stable cash inflows in the future can employ a large amount of debt in their capital structure.
On the other hand, in the case of companies whose cash inflows are unstable and unpredictable, it is quite risky to employ fixed cost funds of finance. Interest coverage ratio is helpful, to check whether EBIT is sufficient to meet the interest charges. Higher the ratio, the greater the amount of debt a company can use.
The ratio is calculated using the equation:
Interest Coverage Ratio = EBIT / Fixed Charges
EBIT = Earnings before Interest and Taxes
Fixed charges includes debenture interest and preference dividend. Preference dividend coverage ratio can also be calculated as –
PAT / Preference Dividend
PAT = Profit after Tax
While designing the capital structure, the existing management may not be ready to give control and ownership of the company to outsiders. This is true especially in the case of firms promoted by entrepreneurs or closely held companies, (that is, in closely held companies, shares are held by family members, for example – Godrej). Another example where the management is not ready to give controlling rights to outsiders is Wipro Ltd. This company has the maximum shares being held by a single family’s members.
The promoter Mr. Aziz Premji and family members have 75 percent shares in the company and Mr. Premji’s brother is having another 15 percent shares in the company. So this is the only company in the world, with 90 percent shares held by the family members.
But in the case of widely held companies, shareholders are spread throughout the world. Shareholders are not interested in taking active part in the management of these companies and they are only interested in the returns. If they are not satisfied, they sell the shares and thereby transfer the rights to outsiders. The shareholders in widely held companies, do not object to giving control to outsiders. Examples are Reliance Ltd, Infosys Ltd, etc.
The holders of debt generally do not have voting rights, therefore if a company wants to avoid the loss of control, it should use debt capital. But if a company uses large amount of debt, the suppliers of funds, especially the financial institutions, put lot of restrictions in the management of the company, to protect their interest. This may affect the freedom of the management to run the business.
Moreover, a high amount of debt can also cause serious liquidity problem and ultimately render the company sick, which means a complete loss of control. So these factors should be considered by the management while designing the capital structure.
Flexibility means the firm’s ability to change its capital structure as per the changing circumstances. That is, the company should be in a position to raise funds, without undue delay and cost, whenever needed, to finance the profitable investments. Moreover, the company should also be in a position to redeem its preference capital or debt, whenever warranted by future conditions. It should also be able to substitute one form of financing for another, to economise the use of debt.
So the financial manager must keep himself in a situation where he can change positions, that is, while designing the capital structure, he should not lose sight of the future impact on the proposed financial plan. A company can enjoy flexibility, if it is in a position to repay debt, or preference capital, or to replace it with a cheaper source of finance.
For example- if funds are available at 15 percent rate of interest per annum, but the company has outstanding debt at 18 percent per annum. The company can save in terms of interest expenses, if it can repay the old debt and replace it by the new debt.
A growing company may find it difficult to raise long term loans or preference capital. Even if it is able to obtain these funds, it will be available at a higher rate of interest and inconvenient terms. So the capital structure of a growing company will be very inflexible, and management cannot run business freely without interference.
Therefore, the growing firms usually depend on equity capital and retained earnings, for their long term funds. But a reputed company and an established one have relative flexibility in designing its capital structure, because funds are available for these firms on easy terms and conditions.
Timing of public issue is also an important consideration in the capital structure decisions of a firm. Substantial public savings may be obtained by firms, by proper timing of security issues. Public offerings should be made at a time when the state of the economy, as well as the capital market is ideal to provide the funds. The monetary and fiscal policies that are pursued by the government are also important in this regard.
The government follows a cheap monetary policy, to boost the economy during a recession and a dear monetary policy, during inflationary periods. For example- when the government reduces the bank rate it reflects itself in prices, as well as yield on debt, securities and equity capital. Generally if the share market is depressed, the company should issue debentures or preference shares. When the share market revives, the company can issue equity shares. During boom period, the company can issue equity shares at a high premium.
Flotation costs are the expenses for raising funds from external sources, For example- advertising expenses, expenses for printing application forms, brochures, prospectus, underwriting expenses, etc., are the flotation expenses. A survey about these expenses showed, that to sell one share, the company has to issue at least 500 application forms. Under writing commission is 2.5 percent for debentures and five percent for equity capital.
Another important thing is that flotation costs as a percentage of funds will decline. Therefore, the company can save in terms of flotation costs, if it raises funds through large issues of securities. Considering all these expenses, retained earnings should be used for financial requirements, because they are funds without flotation expenses.
Factor # 10. Credit Standing of the Company:
The credit standing of the company is an important factor in designing the capital structure. Management’s freedom of choice is extremely limited in the case of newly formed companies. These companies usually rely on equity capital since it is difficult to obtain long term debt, because in the minds of investors, generally, newly formed companies are considered to be more risky, than established firms.
Therefore, such firms do not have ready access to different types of funds from various sources. They are generally in a weak bargaining position in obtaining funds. In contrast, reputed companies can make use of different sources for raising funds, as no single source can cater to their total requirements of funds.
Factors Affecting Capital Structure – Profitability, Cost of Capital, Nature of Business of Firm, Cash Flows, Control of Firm, Capital Market Conditions and a Few Others
The main factors affecting the capital structure of a firm are mentioned below:
The basic objective of financial management of a firm is to maximise shareholders’ wealth. The management should select such a capital structure that maximises EPS for a given EBIT. If operating profits are higher, debt capital can be used in larger proportion, as chances of default on interest on debt are small.
The additional profits are incurred to equity shareholders because of use of other forms of funds, viz., preferential capital and debentures. This type of capital structure provides “trading on equity”.
2. Cost of Capital:
Each source of capital has its specific cost. Debt requires interest payments and share capital holders are paid dividends. The relative advantage incurred in employing different sources in the project in reducing the overall cost of capital will help in deciding the capital structure of a firm. The cost of debt is generally lower than the cost of equity.
3. Nature of Business of Firm:
The nature of business of a firm is a decisive factor in the capital structure. If the firm operates in a perfect competitive market, there are chances of suffering loss. In such a case, the firm should use debt in small proportion so that in case of loss in a year, the burden of interest payment could not affect the business of firm adversely.
4. Cash Flows:
The operating profit should not only cover the interest payments, it should also be sufficient to meet routine obligations and expenditures. The irregular cash flow may cause the requirement of borrowing. Thus, the capital structure should be such that the sufficient cash flows are available and borrowed funds are not required to meet daily requirements.
5. Control of Firm:
If control of the firm has to be in few hands, then low proportion of capital should be raised by issue of equity capital and a larger portion of capital should be raised through issue of debt. The existing firm should raise new capital by issuing debt if it does not want to dilute the control of the firm.
6. Capital Market Conditions:
The capital structure of a firm is affected by the prevailing market conditions at the time of raising the funds. When the securities market bears an optimistic outlook, the issue of equity shares and preference shares might get a better response from investors. If a pessimistic outlook is prevailing in securities market, then raising of funds by issuing debentures might get better response from investors, because of the certainty of the fixed interest rate.
7. Legal Requirements:
While raising the funds, the company management has to follow certain legal requirements. For example, banking companies are required to issue only equity shares to raise funds as per the provisions of the Banking Companies Regulation Act.
8. Tax Benefits:
The payment of interest on debt reduces the tax liability of firm and increases its after tax profits. Thus, payment of interest on debt acts as a tax shield for the firm. While, company pays tax on profit before payment of dividend to shareholders and shareholders are not required to pay tax. Therefore, in framing capital structure, the firm should take into consideration the tax shields available.
9. Growth Prospects:
The growth prospects of a firm also influence its capital structure. Firms with fair growth prospects can use debt in larger proportion and can increase additional benefits for shareholders. Such firms should use debt with lower maturity so that funds can be raised at lower interest rate. If firms are facing financial problems, the lower debt ratio should be employed to avoid situation of financial bankruptcy.
10. Floatation and Other Costs:
Floatation and other costs incurred in raising funds from different sources should be considered while deciding capital structure of a firm. It is better to use retained earnings if the costs in raising the funds from external sources are high.
Factors Affecting Capital Structure – Internal and External Factors
The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to fund its long-term asset. The key division in capital structure is between debt and equity, the proportion of debt funding is measured by gearing or leverages. There are different factors that affect a firm’s capital structure, and a firm should attempt to determine what its optimal, or best, mix of financing. Capital structure of a firm is determined by various internal and external factors.
Following are the main factors which affect the capital structure decision:
1. Nature of Business:
The nature of an organization’s business directly influences its capital requirements, for example manufacturing industries require large investments in plant, machinery, warehouses and others. While, trading concerns need relatively lesser investment in such assets. These assets continue to generate income and profits over an extended period of time. Also, funds which are once invested in fixed assets cannot be withdrawn and put to some other use.
Understanding Capital Requirements:
From the above data we find pantaloons which is into retailing business has more investment in current assets, whereas kingfisher airlines part of aviation business has huge investments in fixed assets.
2. Size of Firm:
Firm size has been empirically found to be strongly positively related to capital structure. Large business organization requires huge capital on account of high volume of operations further these firms are diversified with established profit having goodwill, stability and this enables them to access to the capital market easily as their credit ratings is generally good. On the other hand small size business firms capital structure generally consists of loans from banks and retained profits.
3. Stability of Earning:
Companies that have a proven business model and either are already profitable or offer a clear path to sustainable profitability. Stability in earnings is a measure of accuracy in business, stable earnings are important to a business and features strongly in business planning. If a business organization doesn’t manage its earnings, it may become one of those businesses that go bankrupt every year because they couldn’t manage their earning. In a situation like this a company has no option but to have more borrowed capital in its capital structure.
Stable Earning of ONGC Limited:
4. Growth Stage:
A business firm’s capital structure may also depend upon on its growth stage, most of the companies in preliminary stage have more of debt capital in their capital structure, one of the reason for this is public investors may not subscribe for shares keeping in mind the growth stage of the company. On the other hand more stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.
5. Asset Structure:
Capital Structure is the way a company finances its assets through a combination of equity and liabilities, asset structure represents the proportion of capital employed in each type of asset. A firm that needs more of fixed assets relays on more long term debt. On the other hand firms with relatively greater investment in receivables and inventory rather than fixed assets rely heavily on short-term financing.
6. Control Factor:
A firm’s capital structure generally comprise of equity and/or debt, If a firm has equity capital raised by issuing shares to public it may dilute its ownership stake in business. Because equity investors typically have the right to vote on important company decisions, company management can potentially lose control of their business if they sell too much stock.
Therefore it is important for the management to retain management has 51% of stake in equity capital. On the other hand, when funds are raised through debt capital, there is no effect on the control of the company because the debenture holders have no control over the affairs of the company.
7. Risk Appetite of Management:
Different management risk appetite may bring different changes in capital structure decisions. Risk appetite refers to the level of risk that a management is willing to undertake in its normal course of business. It represents a balance between the potential benefits of new actions that a business organization undertakes and the threats that change inevitably brings.
When deciding on its risk appetite for each category of risk in its capital structure plan, the board of directors should consider the risk capacity of the company. This includes the amount and type of risk it is able to support in pursuit of its business objectives, taking into account its capital structure and access to financial markets.
The external factors which are affecting capital structure are as follows:
1. Corporate Taxes:
Capital structure significantly responds to changing tax incentives, lower taxes have affects the capital structure of firms, resulting in increased equity levels and decreased long-term debt levels. The smaller and more profitable firms are more likely to reduce their debt levels and therefore the trade-off by lowering taxes decrease the incentive to hold debt due to decreasing interest and tax deductibility.
2. Degree of Competition:
In order to survive in the competition a company has to ensure its product are different and more advanced than its competitors, now in order to do this it should spend huge funds on R&D. Further in order to gain momentum and to stay ahead in competition firms have to shell out huge funds on advertisements and promotion. These strategies are likely to result in a high proportion of expenses thereby increasing the need for Capital.
3. Economic Conditions:
Economic condition means the state of the economy that is determined by numerous macroeconomic and micro economic factors, including monetary and fiscal policy, the state of the global economy, unemployment levels, productivity, exchange rates, inflation, business cycles and so on.
As an economy goes through expansion and contraction. Economic conditions are considered to be sound or positive when an economy is expanding, and are considered to be adverse or negative when an economy is contracting. If the market is into recession the company will face the difficulty of raising the money. Hence, they need to invest their own capital, rather than depending upon debt instruments. Thus micro and macro-economic factors influences capital structure of a business enterprise.
4. Government Policies:
Governments create the rules and frameworks in which businesses operate. From time to time the government will change these rules and frameworks forcing businesses to change the way they operate. For example government regulatory bodies such as RBI and SEBI periodically frame regulations pertaining to issue of debentures, shares, payment of dividend, mergers and acquisitions and rate of interest etc. Therefore while deciding capital structure the financial managers should take into consideration these policies.
5. Flotation Cost:
This refers to costs incurred by a company in raising the funds from the market, Flotation costs include the costs of printing the certificates, paying the underwriters, government fees, and registration of the issue, printing of prospectus, advertisement, and payment to the investment banker. Generally, the cost of floating a debt is less than the cost of floating an equity issue.
6. Cost of Capital:
The cost incurred in owning or borrowing capital, including interest payments and dividend obligations. As compared with other securities, the equity shares are more economical because they have least cost of capital, from the company’s perspective payment of dividends is optional giving the company the right to make no dividend payments during challenging trading periods.
A company with a capital structure based largely on debt is required to pay interest to the debt holders, regardless of how the company is performing. However, there may be tax advantages associated with debt repayments.