Capital Structure

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Amount of capital and funds is invested in two types of business assets i.e. fixed asset and current asset. To raise the necessary amount of funds, total requirement of fund is divided into two parts i.e. owner’s fund and outsider’s fund. Owner’s fund is generated by issuing equity share capital and outsider’s fund is generated by issuing preference share capital, debentures and long term finance. The requirement of necessary fund is called capital structure.

Capital structure is a business finance term that describes the proportion of a company’s capital, or operating money, that is obtained through debt and equity. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms.

Capital structure decisions are complex ones that involve weighing a variety of factors. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run. Capital structure refers to the mixture or combinations of sources from which the long term funds required by the business are raised.

For considering the suitable pattern of capital structure, it is necessary to consider basic principles which are as follows and a golden mean by giving proper weight age to each of them

  1. Cost Principle:

According to this principle, idle capital structure should minimize cost of financing and maximizing earning per share.

  1. Risk Principle:

According to this principle, idle capital structure should not accept unduly high risks because loan capital is a risky form of capital and it includes obligations for payments of principles and interest without considering profit or loss of the business.

  1. Control Principle:

According to this principle, idle capital structure should keep controlling position of the owners intact.

  1. Flexibility Principle:

According to this principle, idle capital structure should be able to cater to additional requirement of funds in future. Moreover, the business should avoid capital on such terms and conditions which limit company’s ability to procure additional funds.

  • Important factors while framing Capital Structure

Capital structure is a mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A company’s proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

 Following are important factors to be considered while framing capital structure:

A. Internal Factors:

a) Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of capital should be capable of earning the revenue which will be enough to meet the cost of capital. Sometimes the borrowed funds are cheaper than the equity funds.

b) Risk Factor: While planning the capital structure, it should be noted that, if the company raised the capital by way of borrowings, it accepts the risk in two ways i.e. the company has to maintain the commitment of payment of interest and the installment and secondly the borrowed capital is usually the secured capital and if the company fails to meet its contractual obligations, the lender of borrowed capital may enforce the sale of assets offered to them as security.

c) Control Factor: It plays an important role, especially in case of closely held private limited companies. If the company decides to raise long term funds by issuing further equity shares or preference shares, it dilutes the controlling interest of present share holders or owners. The control does not affect borrowed capital.

d) Object Capital Structure Planning: The capital structure is to be planned in such a way

  • To maximize the profits of the owners of the company.
  • To issue the securities which are easily transferable.
  • To issue further securities in such a way that will not be transferable.
  • To issue such a kind of securities which are acceptable to the lender of capital.

B. External Factors:

a) General Economic Conditions: While planning the capital structure, the general economics conditions should be considered. If the economy is in the state of depression, priority will be given to equity form of capital as it will be involving less amount of risk. But if it is not possible always as the investors may be required to go in the interest rates are likely to decline in future, equity form of capital may be considered immediately, leaving the borrowed form of capital to be tapped in future.

b) Level of Interest Rates: If the funds are available in the capital market, only at the higher rates of interest, the raising of capital in the form of borrowed capital may be delayed till the interest rates becomes favorable.

c) Policy of Lending Institutions: If the policy of term lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital but the equity capital form should be tapped.

d) Taxation Policy: Taxation policy of the government has to be viewed from the angle of both corporate taxation as well as individual taxation. Interest on borrowings is allowed as deduction for income tax purpose while computing taxable income of the company but dividend is considered as appropriation of profit and not allowed as deduction. From the point of view of individual interest as well as will be taxable in the hands of receiver.

e) Statutory Restrictions: The statutory restrictions prescribed by the government are required to be taken into consideration before the capital structure within the overall framework prescribed by the government and framework of law.

C. General Factors:

a) Constitution of the Company: While deciding about the capital structure, constitution of the company plays an important role. In case of private limited company, the control factor may be more important. In case of public limited company, cost factor may be more important.

b) Characteristics of Company: It is important on the basis of the size, age and credit standing of limited company in deciding capital structure. Very small companies and newly started limited companies have to depend more on equity capital because they have limited bargaining capacity and they do not enjoy the confidence of the investors. The companies having good credit standing in the market may be in position to get funds from the sources of their choice.

c) Stability of Earning: If the sales and profit of the company are not likely to be stable over a period of time and are likely to be subject to wide fluctuations, the risk factor plays an important role and company may not be able to have more borrowed capital. However, if profits and sales of the company are fairly constant and stable over a period of time, it may afford to take the risk.

d) Attitude of the Management: If the attitude of the management is too conservative the control factor may play an important role in capital structure decision. If the policy of the management if liberal, the cost factor may get more importance.

  • Importance of Capital Structure

Capital structure planning is very important to survive the business in long run. After simple watching the balance sheet of company, you see two sides of balance sheet. One side is liability side and other side is asset side. Liability side is the mixture of finance of company which company has collected from internal and external sources and it has been used or will be used for development of company.

Liability side of balance sheet is made under perfect capital structure planning. Finance manager and other promoters decide which source of fund or funds should be selected after monitoring the factors affecting capital structures. So, capital structure planning makes strong balance sheet. The right capital structure planning also increases the power of company to face the losses and changes in financial markets. Following points shows the importance of capital structure and its planning.

  1. To reduce the overall risk of company:

When we make capital structure before actual getting money from money supplier, we can do many adjustments for reducing our overall risk. Suppose, we have made capital structure in which we add three sources of fund, one is equity share, and other is debenture and last is pref. shares. Because we know that we have to pay debt at its maturity at any cost and its interest at fixed rate. So, we try to get minimum debt in new business because in new business our rate of return will be less than rate of interest and for getting more loan means taking high risk of return more amount of interest even there is no profit. But, if our business will be succeeded, at that time, we can increase estimated amount of debt by just changing the value of debt in capital structure in excel sheet. We can easily pay the interest because our ROI is very high. At that time, company can enjoy the trading on equity. But finance manager should also careful watch whether shareholders are more expected regarding dividend or not.

  1. To do adjustment according to Business Environment:

Company also adjusts different sources expected amount according to business environment. Suppose in future, if government of India cuts off his relation with China, from where our company is getting fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called maneuverability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure. Suppose, if RBI increases the interest rate, it means your cost for getting debt will be high, at that time, you can choose any other cheap source of fund.

  1. Idea generation of new source of fund:

Good planning of capital structure will make versatile to finance manager for getting money from new sources. How finance managers of company are generating new and new idea for getting money from public at low risk it can be understood from the capital structure.


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