There are three major considerations in capital structure planning, i.e. risk, cost of capital and control, which help the finance manager in determining the proportion in which he can raise funds from various sources. Although, three factors, i.e. risk, cost and control determines the capital structure of a particular business undertaking at a given point of time. The finance manager attempts to design the Capital Structure in such a manner that his risk and costs are the least and the control of the existing management is diluted to the least extent.
Risk - Risk is of two kinds, i.e. financial risk and business risk. Here we are concerned primarily with the financial risk. Financial risk is also of two types:
- Risk of Cash Insolvency: As a firm raises more debt, its risk of cash insolvency increases. This is due to two reasons. Firstly, higher proportion of debt in the Capital Structure increases the commitments of the company with regard to fixed charges. This means that a company stands committed to pay a higher amount of interest irrespective of the fact whether it has cash or not. Secondly, the possibility that the supplier of funds may withdraw the funds at any given point of time. Thus the long-term creditors may have to be paid back in installments even if sufficient cash to do so does not exist. This risk is not there in the case of equity share.
- Risk of Variation in the the Expected Earning to Equity Share-holders: In case a firm has higher debt contenting Capital Structure, the risk of variation in expected earnings available to equity shareholder will be higher. This is because of trading of equity. It is seen that financial leverage works both ways, i.e. it enhances the shareholders returns by a higher or lower than rate of interest. Thus, there will be lower probability that equity shareholder will enjoy a stable dividend if the debt content is higher in the Capital Structure. In other words, the relative dispersion of expected earning available to equity shareholder will be greater of the Capital Structure of a firm higher debt content.
Cost of Capital – Cost is an important consideration in capital structure decision. It is obvious that a business should be at least capable of earning enough revenue to meet its cost of capital and finance its growth. Hence, along with a risk as a factor; the finance manager has to consider the cost aspect carefully while determining the Capital Structure.
Control - Along with cost and risk factor, the control aspect is also an important consideration in planning the Capital Structure. When a company issues further equity share it automatically dilutes the controlling interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect the composition of the Board of Directors in case dividend on such share is not paid for two consecutive years.
Trading on Equity – A company may raise funds either by the issue of shares or by borrowings. Borrowings carry a fixed rate of interest and this interest is payable irrespective of fact where there is profit or not. Preference shareholders are also entitled to a fixed rate of dividends but payment of dividends is subject to the profitability of the company. In case of return on the total capital employed i.e. shareholder’s funds plus long term borrowings, is more than the rate of interest on borrowed funds or the rate of dividends on preference shares, it is said that company is trading on equity.