Determinants of Capital Structure

Capital structure refers to the way a firm chooses to finance its assets and investments through some combination of equity, debt, or internal funds. It is in the best interests of a company to find the optimal ratio of debt to equity to reduce their risk of insolvency, continue to be successful and ultimately remain or to become profitable. The capital structure of a concern depends upon a large number of factors such as leverage or trading on equity, growth of the company, nature and size of business, the idea of retaining control, flexibility of capital structure, requirements of investors, cost of floatation of new securities, timing of issue, corporate tax rate and the legal requirements. It is not possible to rank hem because all such factors are of different important and the influence of individual factors of a firm changes over a period of time.

Determinants of Capital Structure

The factors influencing the capital structure (or determinants of capital structure) are discussed as follows:

  1. Financial Leverage or Trading on Equity: 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. Effects of leverage on the shareholders return or earnings per share have already been discussed in this blog. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners’ investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders’ equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (EPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm’s capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. The earnings per share also increase with the use of preference share capital but to the act fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more.
  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.
  3. Cost of Capital: Every dollar invested in a firm has a cost. Cost of capital refers to the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. The capital structure should provide for the minimum cost of capital. Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimize the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The main sources of finance for a firm are equity share capital, preference share capital and debt capital. The return expected by the supplier of capital depends upon the risk they have to undertake. For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to minimize the overall cost of capital, a company should employ a large amount of debt.
  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 to earnings before interest and taxes. Business risk can be internal as well as external. Internal risk is caused due to improper products mix non availability of raw materials, incompetence to face competition, absence of strategic management etc. internal risk is associated with efficiency with which a firm conducts it 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 cycle.
  5. Cash Flow: One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm’s ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of 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 inflow. Debt financial 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.
  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. The size of a company also greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure.
  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 though the issue of equity shares, the control of the existing shareholder 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 restrictions imposed upon imposed upon by the lenders or suppliers of finance and a complete loss of control by way of liquidation of the company.
  8. Flexibility: Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds.
  9. Requirement of Investors: The requirements of investors is another factor that influence 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, cautions investors and less cautions investor.
  10. Capital Market Conditions (Timing): Capital Market Conditions do no remain the same for ever sometimes there may be depression while at other times there may be boom in the market is depressed and there are pessimistic business conditions, the company should not issue equity shares as investors would prefer safety.
  11. Marketability: Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favors debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary shares to raise finances.
  12. Inflation: Another factor to consider in the financing decision is inflation. By using debt financing during periods of high inflation, we will repay the debt with dollars that are worth less. As expectations of inflation increase, the rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, the financing decision should be cognizant of inflationary trends.
  13. Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner’s capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies.
  14. Legal Considerations: At the time of evaluation of different proposed capital structure, the financial manager should also take into account the legal and regulatory framework. For example, in case of the redemption period of debenture is more than 18 months, then credit rating is required as per SEBI guidelines. Moreover, approval from SEBI is required for raising funds from capital market whereas; no such approval is required- if the firm avails loans from financial institutions. All these and other regulatory provisions must be taken into account at the time of deciding and selecting a capital structure for the firm.

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