Capital structure refers to the mixture of long term funds represented by equity share capital, preference share capital and long term debts. As a matter of fact, capital structure planning is one of the major tasks which involve determination of the right proportion of different securities. Each Corporate security has its own merits and demerits. Too much inclusion of any one kind of security in the capital structure of a company may prove unprofitable or subsequently risky. Therefore, a prudent financial decision should be taken after considering all the factors in view.
Capital structure should always be made in the interest of equity shareholders because they are the ultimate owners of the company. However, the interest of other groups, including employees, customers, creditors, society and government should also be duly considered. In this way, efforts should be made to have capital structure most advantageous. Within the constraints, maximum use should be made of leverage at a minimum cost.
As there cannot be uniformity regarding capital structure decision, which suit the requirements of all companies, Capital structure should be formed to suit the needs of every individual company together with giving due place to borrowed funds in its capital structure.
Factors Determining Capital Structure
Capital structure has to be decided initially at the time when a company is incorporated. The initial capital structure should be designed very carefully wherever funds have to be procured, the financial manager should study the pros and cons of various sources of finance and pick up the most advantageous source keeping in view the target capital structure. A number of factors determine the capital structure of a company. The impact of each factor should be assessed with regard to various considerations like income, risk, control and cost. The task of arriving at a proper mix by balancing a number of conflicting interests and considerations is indeed one of the challenging tasks. While determining capital structure, the following factors should be taken into account.
- Trading on Equity or Leverage: Financial leverage is an important consideration in planning the capital structure of a company because of its effects on the earning per share. The use of fixed cost sources of finance such as debt and preference capital to finance the assets of the company is known as financial leverage or trading on equity. The trading on equity is a device to earn higher earnings on the share capital of a company. However, it is a double-edged sword. It has got tremendous acceleration or deceleration effect on EBIT as well as EPS. It may prove to be blessing if an enterprise uses borrowed capital and earn more on it than pays on it. On the other hand, it may prove a curse for an enterprise having high debt financing but low and uncertain cash flows to meet its debt obligations. The intensity of trading on equity can be measured by the debt-equity ratio or fixed charge ratio.
- Capital Gearing: The different forms and proportion of securities to be issued is decided on the basis of policy decision regarding capital gearing. The ratio of equity share capital to preference share capital and loan capital is described as the “capital gearing”. If equity share capital (including any reserves or undistributed profits which may be regarded as being part of the equity of the ordinary shareholders) is lower than the loan capital, the capital structure is said to be ‘high geared’. On the other hand, if the equity share capital is higher than the loan capital, the capital structure is said to be ‘low geared’. Thus, capital gearing is important not only to the company, but also to prospective investors. It must be carefully planned since it affects a great deal of the company’s capacity to maintain an even distribution policy in the face of any difficult trading periods which may occur. Remarkably, distribution policies and the building-up of reserves as well as an even dividend policy are all affected by the company’s “gear ratio”.
- Cost of Capital: The cost of capital is an important concept in formulating capital structure. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. Ignoring risk, debt is a cheaper source of funds than equity. The preference share capital is also cheaper than equity capital, but not as cheap as debt. The capital structure should frame in a way it kept the total cost of capital t to the minimum. So it is necessary for alternative capital structures to be compared. The term ‘cost of capital’ includes the interest or dividend payable plus the costs incurred in raising the capital such as legal and publicity costs etc.
- Maximum Control: Normally in business life different groups of shareholders are there. They may think in different ways and due to difference of opinions all always try to keep maximum control in their hands. Certain securities have voting rights and therefore, through them control can be exercised. Hence, whenever requirement of additional funds are there, proper balance between the voting capital (the equity capital) and the non voting capital (retained earnings, preference shares, debentures, loans) should be kept so as to maintain proper control. However, it is difficult to determine the ideal ratio. Some accountants may take the view that the absence of loans is a sign of great strength while others may argue that the existence of loans is an indication of growth and profitability.
- Cash Flow Ability of the Company: One of the features of a sound capital structure is conservatism which does not mean employing no debt or small amount of debt. Conservatism is related to the fixed charges created by the use of debt of preference capital in the capital structure and firm’s ability to generate cash to meet these fixed charges under any reasonably predictable adverse conditions. The fixed charges of a company include payment of interest, preference dividends and principal, and they depend on both the amount of loan securities and the terms of payment. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flow to meet the fixed charges. Net cash inflows-fixed charges ratio (debt-servicing ratio) is one of the important ratios which should be examined at the time of planning the capital structure.
- Flexibility: A business cannot run in static affairs. When, the environment changes accordingly the company should change to survive. For this purpose flexibility in capital structure must be there. Here, flexibility means changing of mixture regarding capitals. Such flexibility depends upon certain important factors like flexibility in service charges, restrictive clauses in loan agreements, process of redemption and debt capacity.
- Scale of Company: This is not an important factor and having lowest voice in formation of a capital structure. Normally a small-scale company can’t attract and are nonfavoured by the investors. These companies are compelled to take support of equity shares mostly while large-scale companies can always get favour from investors. Such companies always find leverage as additional advantage in their capital structure.