Capital Structure of a firm has significant impact on aspects like return to shareholders, Cost of Capital and value of a firm, many factors are required to be taken into consideration while framing the Capital Structure of a firm. These are known as the determinants of Capital Structure.
Generally the capital structure is determined taking into account the economic and industrial situation in the country as well as significant circumstances of a particular concern and specific elements.
Learn about the factors determining capital structure:
Some of the internal factors are:
1. Nature of the Business 2. Size of the Business 3. Stability of Income 4. Cost of Capital 5. Objective of Financing 6. Duration of the Project 7. Control over the Firm 8. Flexibility 9. Structure of Assets 10. Trading on Equity 11. Attitude of the Management 12. Age of the Company
Some of the external factors are:
1. Capital Market Conditions 2. Level of Interest Rates 3. Investors’ Attitude 4. Regulatory Requirements 5. Tax Policy and 6. Government Policies
Some of the general factors are:
1. Size of Business and Character of Capital Requirements 2. Growth Age and Size of Firm 3. Operational Characteristics 4. Continuity of Earnings 5. Flexibility 6. Marketability of Securities 7. Government Influence 8. Financial Leverage 9. Market Price of Equity Stock 10. Corporate Taxation
Also learn about some other factors determining capital structure:
1. Control 2. Risk 3. Income 4. Tax Consideration 5. Investors’ Attitude 6. Flexibility 7. Timing 8. Legal Provisions 9. Profitability 10. Growth Rate 11. Government Policy 12. Marketability 13. Company Size 14. Maneuverability 15. Financing Purpose
Factors Determining Capital Structure: Control, Risk, Tax Consideration, Cost of Capital, Trading on Equity, Investors’ Attitude, Flexibility and More…
Factors Determining Capital Structure – Internal Factors and External Factors
Capital Structure of a firm has significant impact on aspects like return to shareholders, Cost of Capital and value of a firm, many factors are required to be taken into consideration while framing the Capital Structure of a firm. These are known as the determinants of Capital Structure.
These can be classified into internal factors and external factors as follows:
Factor # 1. Internal Factors:
The internal factors affecting capital structure include the following:
i. Nature of the Business:
Capital Structure of a firm largely depends on the nature of the business a firm undertakes. Firms that operate in monopoly or oligopoly markets generally have stable income and low business risk as compared to perfectly competitive firms.
As a result, they may employ a higher proportion of Debt Capital in their Capital Structure. On the other hand, perfectly competitive firms face high risk and hence rely more on Equity Capital.
ii. Size of the Business:
Small scale firms generally have lower capital requirements and hence rely mostly on their own capital. Moreover, many times, financial institutions impose strict lending conditions on such firms, as a result of which they are forced to avoid Debt Capital.
On the other hand, large firms get easy access to institutional credit and hence can depend on Debt Capital. Moreover, they also have higher capital requirements which can hardly be met by new issues always. For this reason, they also depend equally on Debt Capital.
iii. Stability of Income:
The Capital Structure of a firm also depends on the stability of its income. Firms which can maintain stable income can easily bear the fixed charges like interest on debt and preference share dividend. Hence, they may depend more on Debt Capital or Preference Share Capital.
However, firms with fluctuating income can hardly manage the burden of fixed charge capital and hence should try to avoid them.
iv. Cost of Capital:
Generally, Debt Capital is associated with lower cost as compared to Equity Capital. Hence, an increase in Debt Capital can significantly reduce the overall or average Cost of Capital. Hence, a firm that intends to minimise their Cost of Capital has to increase the share of Debt Capital in the total capital of the firm.
v. Objective of Financing:
Capital Structure also depends on the objective of financing. In order to finance the normal operating activities, a firm may rely on Debt Capital or Preference Share Capital as the fixed charges can easily be funded from the regular income.
On the other hand, expansion projects which will take time to materialise should preferably be financed by equity share capital or from retained earnings.
vi. Duration of the Project:
This is another important factor determining the Capital Structure of a firm. A firm should finance the projects with fixed completion period through sources like Debt Capital or Preference Share Capital (which are compulsorily redeemable) by properly aligning the maturity profile of the instruments with the period of the projects.
On the other hand, projects, which do not have any fixed completion period, should preferably be financed by equity share capital which is not associated with compulsory redemption.
vii. Control over the Firm:
Since preference shareholders and debt providers do not have any voting right, procurement of additional capital through these sources does not hamper the controlling interest of the existing shareholders.
But if additional capital is financed by issuing new shares to investors other than the existing shareholders, it may dilute the proportionate shareholding and accordingly the controlling interest of existing shareholders, especially the promoter group.
As a result, firms with high promoter shareholding may prefer Debt Capital to Equity Capital. However, at times, large borrowings come with strict debt covenants which may invite unnecessary interference by the debt providers. Hence, this aspect also needs to be taken care of.
Capital Structure of a firm should be flexible. Flexibility means the ease of changing the components of Capital Structure as and when needed.
In order to ensure flexibility, a firm may prefer structured debt instruments or preference shares to traditional equity shares, because convertibility, call ability, etc., can be attached only with these structured instruments and not with equity shares.
ix. Structure of Assets:
Capital Structure decisions are closely associated with the structure of assets of any firm. A firm should avoid financing Current Assets by long-term capital sources. Moreover, a part of the fixed assets may be financed by long-term Debt Capital with matching maturity.
x. Trading on Equity:
Capital Structure of a firm also depends on the possibility and intention of undertaking Trading on Equity. When a firm has its Rate of Return higher than the cost of fixed charge capital, it can increase the return to shareholders by increasing the share of fixed charge capital in the total capital. Hence, in such cases, Capital Structure comprises more Debt Capital and less Equity Capital.
xi. Attitude of the Management:
Capital Structure of a firm also depends on the attitude and outlook of management towards financial risk. Firms with aggressive management are found to rely more on debt than those with conservative management.
xii. Age of the Company:
Newer companies with uncertain futures generally face hardship in getting institutional finance. As a result, they rely more on unconventional funding like private equities, venture capital funds, etc., mostly in the form of equity investments. Thus, their Capital Structure includes a higher share of owned capital than Debt Capital.
Factor # 2. External Factors:
These are factors beyond the control of any firm.
External factors include the following:
i. Capital Market Conditions:
Capital market conditions do not remain uniform throughout the year. As a result, while in a buoyant capital market, new issues are often oversubscribed, at times of slump, companies hardly find buyers for the new shares.
Hence, in such a situation, there remains no other alternative than to resort to institutional financing in the form of loan. Thus, it can be said that capital market conditions do have a significant impact on the Capital Structure a company plans.
ii. Level of Interest Rates:
The current level of interest rates is an important determinant of the Capital Structure of a firm. A firm with relatively low Rate of Return cannot afford to pay high interest and hence may avoid loan financing in periods of high interest rates.
iii. Investors’ Attitude:
Capital Structure of a firm also depends on the attitude of the investors in the capital market. In an economy where investors are mostly risk averse, companies will find it difficult to issue securities in the market and should depend on institutional loans to meet their requirement of funds.
On the other hand, in economies with risk taker investors, new issues of shares, debentures and other innovative products will be the most favoured route.
iv. Regulatory Requirements:
Market regulators of each country issue various regulations to be abided by the issuers of securities. For example, in India, companies cannot issue irredeemable preference shares or rights issues can be made only after a minimum gap from the initial public offering.
Similarly, banking companies are not allowed to issue securities other than equity shares. Thus, a firm’s Capital Structure must be planned taking into consideration all the regulatory requirements of the concerned country.
v. Tax Policy:
Tax policy often plays an important role in determining the Capital Structure of a firm. For example, in India, dividend payment by domestic companies attracts dividend distribution tax resulting in higher Cash Outflow for financing through equity shares.
On the other hand, interest payments are tax deductible and hence offer tax savings. Therefore, other things being unchanged, a company with higher sensitivity towards tax rates may favour debt financing over equity financing.
vi. Government Policies:
Many a times, monetary and fiscal policy measures undertaken by the government significantly affects the Capital Structure of a firm. When the government follows a liberal policy and allows foreign institutional investors to participate in the capital market, companies find it easier to raise required funds by issuing new shares.
Similarly, domestic companies, when allowed to raise finance from international capital markets, enjoy better options to form a sound Capital Structure.
Top 17 Factors Determining Capital Structure
The factors determining capital structure are as follows:
Factor # 1. Control:
The management control over the firm is one of the major determinants of capital structure decisions.
The equity shareholders are considered as the real owners of the company, since they can participate in decision making through the elected body of representatives called ‘Board of Directors’. The policy decisions are taken in general meetings of the equity shareholders and the day to day working will be supervised through the board of directors.
The preference shareholders and debenture-holders cannot participate in decision making. The financial institutions and banks who provide term loans can participate in management through the nominee directors, by having covenant in the loan agreement.
The preference shareholders can exercise voting power in general meetings if the company fails to pay preference dividends for two consecutive years. When the promoters do not wish to dilute their control, the company will rely more on debt funds. Any fresh issue of shares will dilute the control of the existing shareholders.
Factor # 2. Risk:
In capital structure decisions, two elements of risk viz.-
(i) business risk and
(ii) financial risks are considered.
Business risks are influenced by demand, price, input costs, fixed costs, business cycles, competition etc.
The business risk of a firm is determined by the accumulated investments the firm makes over time. A firm with high business risk prefers to have low levels of debt, since the volatility of its earnings is more.
A firm with low level of business risk can have a higher debt component in capital structure, since the risk of variations in expected earnings is lower. Financial risks representing the risks from financial leverage.
It refers to the additional variability per share and the increased probability of insolvency that arises when a firm uses fixed cost source of funds i.e. term loans, debentures and bonds. The higher proportion of debt increases the commitments of the company with regard to fixed charges and repayment of principal amount in time.
Factor # 3. Income:
Increase of return on equity shareholders depends on the method of financing and its impact on EPS and ROE. If the level of EBIT is low from EPS point of view, equity is preferable to debt. If the EBIT is high from EPS point of view, debt financing is preferable to equity.
If the ROI is less than the cost of debt, financial leverage depresses ROE. When the ROI is more than cost of debt, financial leverage enhances ROE.
Factor # 4. Tax Consideration:
Under the provisions of the income-tax act, the dividend payable on equity share capital and preference share capital are not deductible, causing the high cost of equity funds. Interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds.
The debt has tax advantage over equity. By increasing the debt component in the capital structure, a firm can increase its earnings available to shareholders. The flotation costs of debt and equity are deductible over a period of 10 years. Premium on redemption can be deductible during the maturity period.
Factor # 5. Cost of Capital:
Cost of different components of capital will influence the capital structuring decisions. A firm should possess earning power to generate revenues to meet its cost of capital and finance its future growth. Generally the cost of equity is higher than the cost of debt, since the debt holders are assured of a fixed rate of return and repayment of principal amount after the maturity period.
Firms that adjust their capital structure in order to keep the riskiness of their debt and equity reasonable should have a lower cost of capital. A firm with a high level of gearing, its ability to meet fixed interest payments out of current earnings diminishes. This increases the probability of bankruptcy and as a result, the cost (risk premium) of both debt and equity raises.
Factor # 6. Trading on Equity:
The basic objective of financial management is to enhance the wealth of the firm by increasing the market value of the share. The firm’s wealth is increased, if after tax earnings are increased. A company raises debt at low cost with a view to enhance the earnings of the equity shareholders.
The cost of debt is lower due to tax advantage. A fixed rate of return is payable on debt funds. Any excess earnings over cost of debt will be added up to the equity shareholders. Capital structure decisions should always aim at having debt component in total component in order to increase the earnings available for equity shareholders.
Factor # 7. Investors’ Attitude:
In a segmented market, different sets of investors measure risk differently or simply charge different rates on the capital that they invest. By choosing the instrument that taps the cheapest market, firms lower their cost of capital. However, the trade-off in terms of availability of funds always exists.
Factor # 8. Flexibility:
It is more important consideration with the raising of debt is flexibility. As and when the funds required, the debt may be raised and it can be paid off and when desired. But in case of equity, once the fund raised through issue of equity shares, it cannot ordinarily be reduced except with the permission of the court and compliance with a lot of legal provisions.
Hence, debt capital has got the characteristic of greater flexibility than equity capital, which will influence the capital structure decisions. A firm maintains its borrowing power to enable it to raise debt to meet unforeseen contingencies.
Factor # 9. Timing:
The time at which the capital structure decision is taken will be influenced by the boom or recession conditions of the economy. In times of boom, it would be easier for the firm to raise equity, but in times of recession, the equity investors will not show much interest in investing. Then the firm is to rely on raising debt.
Factor # 10. Legal Provisions:
Legal provisions in raising capital will also play a significant role in planning capital structure. Raising of equity capital is more complicated than raising debt.
Factor # 11. Profitability:
A company with higher profitability will have low reliance on outside debt and it will meet its additional requirement through internal generation.
Factor # 12. Growth Rate:
The growing companies will require more and more funds for its expansion schemes, which will be met through raising debt. The fast growing companies will have to rely on debt rather than on equity or internal earnings.
Factor # 13. Government Policy:
The government policies and capital market regulation is a major determinant in capital structure. For example, an increase in lending rates may cause the companies to raise finances from the capital market.
Rigid capital market policies may cause to raise finances from banks and financial institutions. Monetary and fiscal policies of the government will also affect the capital structure decisions.
Factor # 14. Marketability:
The balancing of debt and equity is possible when the marketability is created for the company’s securities. The company’s ability to market its securities will affect the capital structure decisions.
Factor # 15. Company Size:
The companies with a small capital base will rely more on owner’s funds and internal earnings. But large companies have to depend on the capital market and can tap finances by issue of different varieties of securities and instruments.
Factor # 16. Maneuverability:
The balancing of capital structure is drawn when the firm has maneuverability on funds raised by expanding and contracting the outstanding balances to the funds requirement of the firm. By having different types of securities with different maturity periods, recall provisions, the company can optimize its capital structure and enhance its borrowing power.
Factor # 17. Financing Purpose:
The capital structure decisions are taken in view of the purpose of financing. The long- term projects are financed through long-term sources and in the form of equity.
The short-term projects are financed by issue of debt instruments and by raising of term loans from banks and financial institutions. The projects for productive purpose can be financed from both equity and debt. But the non-productive projects are financed by using the internal generated earnings.
Factors Determining the Capital Structure – Cost of Capital, Nature and Size of a Firm, Flexibility, Control, Capital Market Conditions, Purpose of Financing, The Period of Finance, Legal Requirements and More…
The capital structure of a company is to be determined initially at the time of floating the company, while determining the capital structure the following factors must be kept in view
Factor # 1. Cost of Capital:
Cost of capital refers to the minimum return expected by its suppliers of funds. The capital structure should provide for the minimum cost of capital. While formulating a capital structure, an effort must be made to minimize the overall cost of capital.
Factor # 2. Nature and Size of a Firm:
Nature and size of a firm also influences its capital structure. A concern, which cannot provide stable earnings due to the nature of its business, will have to rely mainly on equity share capital. A concern whose earnings are stable due to the nature of its business can offer to have more debt financing in its capital structure.
Factor # 3. Flexibility:
Capital structure of a firm should be flexible i.e., it should be capable of being adjusted according to the needs of the changing conditions. It should be possible to raise additional funds without any difficulty or delay.
Factor # 4. Control:
The capital structure of a company is also influenced by the policy of control. If the shareholders are not interested in inviting new members to enter the company, then debt financing is preferable. If the shareholders have no objection in inviting the new members to enter the company then they can think of raising funds through equity shares.
Factor # 5. Capital Market Conditions:
Capital market conditions are ever changing. Sometimes there may be a boom in the market while at other times there may be depression in the market. If the share market is in boom, it would be advisable to issue equity shares but in case of depression the company should go for debt financing.
Factor # 6. Purpose of Financing:
Purpose of financing is another factor that influences the capital structure of a firm. If funds are required for productive purposes, borrowed funds are suitable and the company should go for issue of debentures as interest can be paid out of the profits generated from such investments. However, if funds are required for unproductive purposes, the company should prefer equity share capital.
Factor # 7. The Period of Finance:
The period for which finance is required also affects the determination of capital structure. In case the funds are required for a long-term requirement say 8 to 10 years, it will be appropriate to raise borrowed funds. However, if funds are required more or less permanently, it will be appropriate to raise them by the issue of equity shares.
Factor # 8. Legal Requirements:
The finance manager has to keep in view the legal requirements while deciding about the capital structure of the company.
Factor # 9. Marketability:
To obtain a balanced capital structure it is necessary to consider the ability of the company to market corporate securities.
Factor # 10. Timing:
Closely related to flexibility is the timing for issue of securities. Proper timing of the security issue often brings substantial savings because of the dynamic nature of the capital market.
Intelligent management tries to anticipate the climate in the capital market with a view to minimize the cost of raising funds and also to minimize the dilution resulting from an issue of new ordinary shares.
Factor # 11. Requirement of Investors:
Different types of securities are issued to different classes of investors according to their requirement.
Factor # 12. Provision for Future:
While planning capital structure the provision for future requirement of capital is also required to be considered.
Top 5 Factors Determining Capital Structure – Availability of Sources of Funds, Debt Equity Ratio, Cost of Capital, Flexibility and Value Maximisation
Factors determining capital structure are as follows:
Factor # 1. Availability of sources of funds:
This may depend upon the economic environment prevailing at the time of fund requirements for the business activity the company is going to start.
At the same time various sources, which can provide the fund should be having surplus funds at their disposal. Besides the economic environment and availability of funds, the project must be a viable proposal for the fund providing institutions.
Factor # 2. Debt equity ratio:
The next point to be examined is the ratio of debt and equity which the organization has to maintain. This factor is dependent upon other factors including financial leverage.
Debt equity ratio is important from the viewpoints of the shareholders of the company.
Factor # 3. Cost of Capital:
This factor needs to be examined while designing the capital structure of an organisation. Cost of capital depends upon the financing mix, i.e., various sources of finance.
Factor # 4. Flexibility:
Capital structure comprises equity capital and loan capital. These have a proportion in the total capital structure.
There should be flexibility for interchange between the two, i.e., loan capital and equity capital. The flexibility means, to change the proportion of debts and equity capital in the capital structure.
This would be possible only when the terms and conditions of the various sources have been planned and agreed to, in the desired proposition. This is very essential in the fast changing global economic scene.
Factor # 5. Value Maximisation:
Value maximisation through improvement, in profitability and return to the equity capital holders is most important. There should be continuous improvement in the profitability of the organisation. This would depend more upon the capital structure.
7 Important Factors Determining Capital Structure – Financial Distress, Agency Cost, Product Life Cycle, Control, Flexibility, Cash Flow and Legal Implications
Following are a few important factors to be considered while determining capital structure:
1. Financial Distress:
Financial distress means a situation in which a firm faces difficulty in paying out its interest and principal towards repayment of debts. As we know that the value of the levered firm is more than the value of the unlevered firm.
But before going levered or increasing leverage, every firm should keep in mind that the cost associated with debt should not be more than benefit from that debt. In case cost is more than benefit there will be a situation of financial distress. As the debt proportion increases in capital structure, financial risk also increases and chances of financial distress also increase.
The firm should establish a tradeoff cost and benefit associated with debt financing. The financial distress brings down the value of the firm.
Thus, the value of a levered firm = Value of an unlevered firm + PV of tax shield – PV of cost of financial distress.
2. Agency Cost:
The claim of equity shareholders and debt holders is not in the same position. Debt holders have primary claim over the firm’s assets and earnings. On the contrary, equity shareholders have residual claims over the firm’s assets and earnings. Due to variability of claim, there may be some conflict between debt holders and equity shareholders.
The equity shareholders always want to increase their value and earnings. On the other hand, the debt holders want to secure themselves because equity shareholders manage and control the firm.
To secure their interests, the debt holders may impose some restrictions upon the firm in the form of representatives in the board, regular financial analysis, regular submission of reports on financial position, maintenance of certain ratios etc.
All these restrictions involve some indirect cost, these indirect costs are called agency cost. Agency costs increase as the leverage increases i.e. increase in debt proportion. Agency cost may be direct also in the form of increased rate of interest and prices also.
3. Product Life Cycle:
At the start up stage, the risks are high therefore, equity, being risk capital per se, is usually the primary source of finance. The startup firm cannot assume additional risks associated with financial leverage. During the growth stage, the risk of failure decreases and the emphasis shifts to financing growth.
Rapid growth generally signals significant investment needs and requires huge sums of capital to fuel growth. This may entail large doses of debt and periodic induction of additional equity capital. As growth slows, seasonality and cyclicality become more apparent. As the business reaches maturity stage, leverage is likely to decline as cash flows accelerate.
The equity shareholders control the affairs of the firm. The issue of new equity shares may dilute the control of present shareholders. The management may go for debt financing. The debt holders do not control the affairs of the firm. The preference shareholders also do not control over the firm.
They cannot vote on every resolution. The preference shareholders can vote only on the issues which are going to affect their interests. The debt holders do not directly control the affairs of the firm but in some cases they impose a condition to appoint their representative in the board of directors.
Flexibility means that as and when a required firm may raise funds. Sometimes firms need funds urgently, in that situation there should not be unwanted delays in raising funds.
The capital structure should be flexible enough to adopt changing market situations like, if the share market is favorable raising funds from issue of shares and in debt market is favorable raising funds from debts.
6. Cash Flow:
While determining its capital structure a firm must consider its cash flow. There may be firms which generate high surplus funds due to less investment in working capital and other firms which generate low surplus funds due to high investments in working capital.
The firms with high surplus funds should go for debt financing because due to surplus funds it can meet its obligation towards payment of interest and repayment of principals.
The firms with low surplus funds should go for equity financing because in case of equity financing, it is not an obligation to pay dividend to the equity shareholders. The firms may defer the payment of equity dividend. Every firm which is going to raise funds should analyze its cash inflow and outflow.
7. Legal Implications:
Every firm planning for raising funds should consider legal implications of every source of finance. There are certain guidelines and legal regulations for every source of finance. In case a firm fails to fulfill these regulatory requirements, it may face penalties from regulatory authorities.
Top 14 Factors Determining the Capital Structure of a Company (With Principles)
Following are the important factors that determine the capital structure of a company:
Factor # 1. Financial Leverage or Trading on Equity:
The financial leverage may be described as the use of fixed interest/dividend bearing securities (debentures and other long-term debt and preference shares) with the owners’ equity in the total capital structure of the company.
If, in the capital structure, the fixed interest/dividend bearing securities are greater as compared to the equity capital, the leverage is said to be larger. In a reverse case, the leverage is said to be smaller.
Financial leverage is said to be favourable when the firm earns more than the cost of funds invested in the fixed assets, and unfavourable when the firm does not earn as much as the cost of the funds invested.
In other words, financial leverage is said to be favourable when the rate of profit is higher than the rate of interest on the funds invested and unfavourable when the rate of profit is lower than the rate of interest on the funds invested.
Financial leverage is also sometimes called trading on equity.
The effect of leverage is more pronounced in case of debt on account of the following:
i) Cost of debt (i.e. interest payment) and fixed return on preference shares (i.e. fixed rate of dividend) is lower than the cost of equity shares (i.e. rate of dividend.
i) Interest paid is a charge on profits and is allowed under Income Tax Law.
Because of its effect on the earning per share, financial leverage is an important consideration in planning the capital structure.
Subject to the stability of earnings and suitability of collateral assets, a company may undertake trading on equity and include more of preference shares and debentures in the capital structure with low-gearing as far as proportion of equity shares is concerned.
Factor # 2. Idea of Retaining Control:
Different types of securities issued by a company possess varying voting rights. Preference shares and debentures, for example, do not carry voting rights in the normal administration of the company. But equity shares enjoy voting rights and hence, they exercise control over the company.
The promoters of many companies therefore issue less of equity shares and more of preference shares and debentures in order to retain control in their own hands. The promoters want public money without public participation in the management.
They want the investors’ money without surrendering to them either the control of business or the right to exceptional earnings.
Factor # 3. Elasticity of Capital Structure:
The financial plan should be so designed as to be elastic in nature. Too much dependence on debentures and preference shares make the capital structure rigid because it involves the payment of fixed charges which may not be within the range of earning capacity of the company, particularly in the initial years.
The general practice is to issue equity shares at the time of inception of the company and depend upon debentures and preference shares in times of emergency or for expansion purposes.
Factor # 4. Cost of Financing:
The cost of finance is another important factor that influences the selection of different types of securities to be issued. The cost of finance includes interest, dividend, underwriting commission, brokerage, listing charges etc.
The securities which involve minimum cost should be preferred. Generally, debentures are issued when interest rates are low and equity shares are issued when the earning and price relationship of shares is high.
Factor # 5. Kinds of Investors:
While issuing different types of securities, requirements of different kinds of investors should be taken into account. On the basis of their financial status, the investors may be classified as upper class, middle class and lower class.
The people belonging to lower class generally prefer equity shares of lower denominations and persons belonging to middle class prefer to invest in preference shares of little higher denominations while persons belonging to upper class purchase debentures of higher denominations. In this way, the capital structure can be made attractive to all types of investors.
On the basis of their attitudes, the investors may be classified as cautious, less cautious and venturesome. The cautious investors care for security of principal and stability of income. So they prefer to purchase debentures. The less cautious investors care for safety of their investment and relatively higher rate of return.
So they prefer to purchase preference shares. The venturesome investors are those who are prepared to take risk and participate in the management as well as capital appreciation. So they go in for equity shares.
Factor # 6. Money Market Conditions:
While devising the financial structure of a company, the money market conditions should be taken into account. Money market conditions can be broadly classified as inflationary or boom and deflationary or depression.
During the boom, when people have enough money, equity shares can be issued. But during depression, when business is dull and the possibility of earning profit is not certain, preference shares or debentures may appeal to investors because they assure a fixed return on their investment.
Factor # 7. Nature of the Business:
The nature of the business of the company also influences the selection of different types of securities. Manufacturing industries operating under competition have to issue equity shares because their earnings are not stable to warrant the issue of debentures or preference shares.
For public utilities which have an assured market and whose earnings are certain and stable, debentures are the ideal securities.
The public utilities can make regular payment of fixed interest and also provide for their repayment. Service and merchandising enterprises which possess fewer fixed assets cannot issue debentures because of their inability to offer their assets as security.
Factor # 8. Simplicity of Capital Structure:
The capital structure of the company should be as far as possible simple, because it is easy to manage and understand and it avoids unnecessary complications. Simplicity can be achieved by issuing only one class shares and debentures.
Factor # 9. Conservative Capital Structure:
The capital structure of the company should be conservative in the sense that it is made up of higher grade securities. Such a capital structure offers several advantages to the company, e.g.
(i) The cost of financing will be lower in the long run.
(ii) It is possible for the company to raise funds even in bad times.
(iii) It is possible for the company to sell whatever types of securities suited to the market conditions, when it is in need of additional funds.
(iv) It is also possible for the company to meet unforeseen difficulties without any danger.
(v) Finally, it is also possible for the company to maintain good relations with the shareholders.
Factor # 10. Provision for Future:
While devising the financial plan, future needs of the company should be taken into account so that the company should be able to meet any contingencies or emergencies unsuccessfully.
For this purpose, the company generally keeps the best security or some of the best securities to the last instead of issuing all types of securities in the beginning.
Factor # 11. Purpose of Financing:
The purpose of financing also affects the capital structure of the company to some extent. If funds are required for some directly productive purposes, say, for purchasing new machinery, the company can afford to raise funds by issuing debentures. Because the company will have the capacity to pay interest on debentures out of the profits so earned.
On the other hand, if the funds are required for non-productive purposes, say for providing welfare facilities to the company’s employees such as construction of a hospital or school building or residential quarters etc. then the company should raise funds by the issue of equity shares.
Factor # 12. Period of Finance:
The period for which the funds are required also affects the capital structure of the company. If the funds are required for 3 to 5 or 10 years, it should raise them by issuing debentures rather than by issuing shares.
Because the debentures can be easily repaid after 5 or 10 years when the company’s financial position has unproved and the company has created out of annual profits a separate fund known as debenture redemption fund.
The repayment of debentures out of such a special fund does not affect the company’s financial position. But if the funds are raised by the issue of equity shares, their repayment creates legal problems because equity shares cannot be redeemed during the life-time of the company, even though the company is in possession of ample funds.
Even issue of redeemable preference shares should not be taken resort to, because their repayment also creates certain legal problems. However, if the funds are required more or less permanently, it will be appropriate to raise the funds by issuing equity shares.
Factor # 13. Legal Requirements (Government Policy):
Every company has to comply with the legal requirements regarding the issue of different types of securities. Therefore the hands of the management are tied by these legal restrictions.
For example, in India, the banking companies are not allowed to issue any type of securities except equity shares under the Banking Regulation Act. Again under the provisions of the Capital Issues Control Act in India companies have to maintain a fixed ratio of 4:1 between debt and equity and 3:1 between equity and preference shares.
Besides this the monetary and fiscal policies of the Government also affect the capital structure decision of the companies. Within the legal framework, the company has to devise its capital structure.
Factor # 14. Possibilities of Regular and Fixed Income:
The stability of the capital structure of a company depends considerably upon the possibility of regular and fixed income.
A.S. Dewing has propounded the following three principles in this connection:
i) If the company expects adequate regular income in future, it can reasonably issue debentures.
ii) The company can issue preference shares if it does not expect regular income in future but it hopes that its average earnings for a few years to come may be equal to or in excess of the amount of dividend to be paid on such preference shares.
iii) If a company does not expect any regular income in future, it should never issue any type of securities other than equity shares. This means that if the company’s future income is uncertain, it has to issue only equity shares.
The above mentioned factors must be borne in mind by the financial executives while devising the capital structure of the company.
8 Major Factors Determining the Capital Structure – Trading on Equity, Cost of Capital, Cash-Flow Needs, Intention to Retain Control, Period of Financing, Market Sentiment and More…
Following are the factors that determines the capital structure:
1. Trading on Equity:
The word ‘equity’ denotes the ownership of the company. Trading on equity means taking full advantage of equity share capital over borrowed funds on reasonable bases. It refers to the additional profits that equity shares earn because of issuing other forms of securities, viz., preference shares and debentures.
2. Cost of Capital:
For a company every source of capital is accompanied by a cost e.g., loans require interest payments while shares require dividends. Although interest is a compulsory payment, generally the rate is not as high as what is expected by the shareholders as dividend on shares.
3. Cash-Flow Needs:
A company must have enough cash to meet routine obligations and day-to-day expenditure. Otherwise, it may lead to insolvency. Therefore those companies, which have irregular cash-flow, should not depend on borrowed funds while deciding the capital structure.
4. Intention to Retain Control:
If the existing management wants to retain the control of the company, it should not raise funds through equity.
5. Period of Financing:
When funds are required for permanent investment in a company, equity share capital is preferred. But when funds are required to finance expansion programmes and the management feels that it will be able to redeem the funds within the lifetime of the company, preference shares and debentures are better.
6. Market Sentiment:
Which securities must find a dominating place in the capital structure, will also depend on the sentiment prevailing in the securities market. When the securities market bears an optimistic outlook, issue of equity shares and preference shares might get a better response from the investing public.
If the securities market is dominated by pessimistic considerations, issue of debentures might get the desired response, because of the guarantee of the fixed interest rates.
7. Appeal to Investors:
Different types of securities appeal to different categories of investors. Equity shares are issued to attract the people who have the desire to have a say in the management of the company. Debentures and preference shares are issued to attract those people who prefer security of investment and certainty of return on investment.
8. Legal Requirements:
While issuing different securities, the company management is also guided by legal considerations. For example, in India, a banking company can only issue equity shares as per the provisions of the Banking Companies Regulation Act.
Factors Determining Capital Structure – Internal, External and General
The factors determining capital structure are as follows:
(i) Cost of Capital
The current and future cost of each potential source of capital should be estimated and compared.
Ordinarily, debt securities increase risk, while equity securities reduce it. Risk can be measured to some extent by the use of ratio, measuring gearing up and times-interest earned.
(iii) Dilution of Value
A company should not issue any shares which will have the effect of removing or diluting the value of the shares by the existing shareholders.
A company can borrow only if investors are willing to lend. Few companies can afford the luxury of the capital structure which is unacceptable to financial institutions.
Many companies put their securities for quotation on the stock exchange quotations and improve the transferability of shares.
(vi) Matching Fluctuating Needs against Short-term Source
Where needs are fluctuating, a firm may prefer to borrow short-term loans from commercial banks.
(vii) Increasing Owner’s Profits
Profits of the owners can be increased by relying more and more on debt financing.
(viii) Surrender Operational Control
Equity stock may result in a possible increase of operational control in an enterprise.
(ix) Future Flexibility
A firm generally maintains a balance to ensure future flexibility in the capital structure.
(i) General Level of Business Activity
Where the overall level of business activity is rising, a firm would want to expand its operations.
(ii) Level of Interest Rates
If interest rates become excessive, firms will delay debt financing.
(iii) Level of Stock Prices.
(iv) Availability of Funds in the Money Market
The availability of funds in the money market affects a firm’s ability to offer debt and equity securities.
(v) Tax Policy on Interest and Dividends
Although each management makes its own decisions on its capital sources, there are certain general factors which seem to influence the overall capital structure.
(i) Size of Business and Character of Capital Requirements:
Though new and big firms are conservatively financed, they are likely to issue new securities to the public. If an enterprise is especially successful, it grows rapidly and may issue bonds and preferred stocks without diluting equity stock interest.
For companies which expand rapidly, even though their current earnings are low, the sale of equity stock is not desirable. However, if assets are plentiful, borrowing is possible.
The tradition of issuing mortgage bonds encourages borrowings by those firms that have heavy investments in fixed assets. In some industries, very large quantities of current assets account for a bigger proportion of the total assets.
(ii) Growth Age and Size of Firm:
The capital structure of firms are different at various stages of their development. In the early years of rapid development, equity capital and short-term growth are principal sources.
As earnings improve, re-invested lendings and long-term debts constitute additional capital. As a firm grows in size, the rate of its internal expansion declines and retained earnings replace the sources of bonded debts, probably through sinking fund payments.
In each field of economic activity, capital structure and the nature of debt are influenced by the size of a company; and equity ratios tend to vary directly with this size.
(iii) Operational Characteristics:
Businesses differ in their operational characteristics and their need for funds. Merchandising firms operate on a small margin of gross profit, mainly with current assets. Public utilities, on the other hand, have small gross incomes relative to their capital and require extensive capital.
The margin of profit is high and investment is heavy in fixed assets. Public utilities are thrown into bankruptcy if their fixed charges are not covered.
(iv) Continuity of Earnings:
A firm must have stable earnings in order to handle recurring fixed charges. Non-durable consumer goods enjoy the stability of demand and rigidity in prices as compared to durable consumer goods. The earnings of some individual companies are fairly regular, though many of them suffer from changes in economic conditions.
The capital structure of all firms in the industries should be more conservative than that of industries which are stable. In the final analysis, the nature of earnings should be the guiding principle in determining an enterprise’s capital structure.
A firm which is conservatively financed carries a fairly small debt; and the one which is heavily mortgaged is no longer able to choose from among the financial alternatives available to it; but has to get funds by whatever means open to it.
The nature of the capital structure is influenced by a struggle to maintain managerial control. If a wise dispersal of ownership is desired, it is assured that a firm will save additional stocks.
(vi) Marketability of Securities:
The financial management of a corporation watches changes in the market psychology and considers them carefully in planning new security offerings. General economic conditions develop new attitudes in the market.
(vii) Government Influence:
Taxes exercise a major influence on the capital structure of different businesses. Corporate income-tax has reduced the net earnings of companies and debt financing is encouraged because of income-tax leverage.
(viii) Financial Leverage:
Unfavourable financial leverage indicates a low level of profitability and makes borrowings more costly than the returns on investment. Stated in another way, the rate of return is less than the rate of interest. It is difficult for a firm to issue additional stocks when profits are low. The only alternative for the firm, therefore, is to raise profits and improve the financial leverage.
(ix) Market Price of Equity Stock:
Equity shareholders usually view additional debt as a risk- increasing measure. It may also be interpreted in terms of a favourable financial leverage. In that case, it may act as a stimulant to equity stockholders and equity stock prices may rise in the market.
If the overall cost of capital is low it is likely that equity stockholders may assume that the firm cannot afford to pay a higher cost of capital and that its projects may, therefore, earn low rates of return. On the other hand, if the cost of capital is high, it may be assumed that a firm cannot exploit lucrative profit opportunities.
The effects on the market price of common stocks cannot, therefore, be easily predicted. In other words, the behaviour of equity stockholders in the market is rather unpredictable.
(x) Corporate Taxation:
Corporate taxes have several effects on the capital structure. Interest charges are tax deductible and the use of debt securities thus provides a lower cost of financing than preferred stock or equity securities. The level of taxes affects the cost of capital, for the lower cost of debt resulting from a tax leverage reduces the overall cost of capital.
13 Important Factors Determining Capital Structure – Degree of Control, Statutory Requirements, Flexibility of Financial Plan, Capital Market Condition and More…
The important factors determining capital structure are as under:
1. Trading on Equity:
The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrow funds on a reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares.
It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.
2. Degree of Control:
In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders.
Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
3. Nature of Business:
The most important determinant of capital structure of a company is the nature of the business itself. Businesses having more risks and unstable income should prefer equity shares. But firms engaged in public utility services or producing the commodity of basic necessity may resort to debentures and preference shares.
4. Age of the Company:
Since a considerable amount of risk is involved in starting a new business, its ideal capital structure is one in which equity share is the only type of security issued. A new company of large size will have to tap all possible sources of capital to secure requisite quantity of funds.
On the other hand well established companies with stable earnings records are always in a better position to raise capital from whatever source they like.
5. Statutory Requirements:
The legal and statutory requirements of the government also influence the capital structure. For example, Banking companies are prohibited from issuing any type of security except equity shares. Similarly, SEBI guidelines on investors’ protection maintaining debt-equity ratio and current ratio as per norms, promoters’ contribution etc. have direct bearing on capital structure.
6. Flexibility of Financial Plan:
In an enterprise, the capital structure should be such that there are both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plants.
Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
7. Choice of Investors:
The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind; of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
8. Capital Market Condition:
In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in periods of boons and inflation, the company’s capital should consist of share capital generally equity shares.
9. Period of Financing:
When a company wants to raise finance for a short period, it goes for loans from banks and other institutions; while for a long period it goes for issues of shares and debentures.
10. Cost of Financing:
In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of a company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
11. Stability of Sales:
An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit.
Therefore, when sales are high, thereby the profits are high and the company is in a better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If a company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
12. Size of a Company:
Small size business firm’s capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.
13. Taxation Policy:
High corporate tax, high tax on dividend and capital gain directly influence the capital structure decisions. High tax discourages the issues of equity shares and encourages issuing more debentures.
Factors Determining Capital Structure – Internal and Significant Factors
Generally the capital structure is determined taking into account the economic and industrial situation in the country as well as significant circumstances of a particular concern and specific elements.
The various factors, which have to be considered while determining capital structure, may be put into two categories—First Internal factors and second external factors.
Among internal factors the following are most important:
1. Certainty, adequacy and regularity of income greatly and deeply affects the capital structure.
2. Capital structure is also affected by promoters of the enterprise, its directors and their relative’s desire as to what extent they wish to have control over the enterprise.
3. The proportion of debt capital in total capital structure should be decided after making proper evaluation of debt-capacity and estimating the risk.
4. The cost of all sources of capital is not found to be identical. As such, while determining the capital structure, the average cost should be calculated and examined. The combination of various sources at which the average cost is minimum is considered as the optimum combination.
5. Nature of business and required asset structure for it also affects the capital structure. The nature of some businesses is such that it requires more fixed assets than current assets. Firms engaged in such business capital structure may include equity capital and debt capital should also be given proper weightage.
6. Financial policies (especially with regard to trading on equity, capital gearing, and financial leverage) also affect the financial structure/capital structure.
The capital structure emerging from above internal factors need not remain in the same form in real practice. There are so many external factors which may compel modifications in the form of capital structure.
Few more significant factors:
(i) The impact of capital market conditions on capital structure is too much. For example, during the recession period, debentures are more popular and attractive as compared to equity shares. In such a period, the issue of debentures is more appropriate and profitable, notwithstanding the less significance of debt in capital structure.
(ii) Capital structure is also affected by the psychological state of investors and their averseness towards the risk. Few investors are venturous and few are interested in some fixed income. Taking into account the state of mind of these investors, various types of securities are issued.
(iii) There are expenses to be incurred on capital issue, i.e., issue of securities requires expenses to be incurred like commission to underwriters, brokerage, stamp duty, etc. These expenses may be high or low depending upon each and every security separately. As such, these expenses are also to be considered while determining the capital structure.
(iv) Capital structure is also affected by Government control, regulation and law. A number of laws are being framed in the country relating to the issue of various types of securities and income accrued thereon. They also play a role in determining the capital structure.
Factors Determining Capital Structure of a Company – Risk, Control, Profitability, Cost of Capital, Trading on Equity, Flexibility, Attitude of the Investors and More…
Determining optimum capital structure is a difficult task.
Following are the factors which should be kept in view while determining the capital structure of a company:
Factor # 1. Risk:
While deciding about the capital structure of a firm, one needs to estimate the two types of risks i.e. business risk and financial risk. Business risk arises due to change in demand, price, competition, costs such as input costs and fixed cost. A firm with higher business risk will borrow less because they do not have a stable earnings trend.
Whereas, firms with lower business risk may borrow more as their earnings are stable.
There are less variations in the earnings of such firms due to changes in price, demand and competition. Financial risk is the risk that arises due to financial leverage. It is the increased probability of insolvency or risk that arises when the firm uses fixed cost (interest) bearing sources of funds like debentures, bonds and term loans.
Higher use of debt increases the commitment of the firm with regard to fixed charges (interest) and repayment of principal amount. Non-payment of these fixed charges may push the company into liquidation.
However, if a company uses equity capital, there is no such fixed commitment. Dividend is payable only when there are enough profits and equity capital is not refunded during the lifetime of the company.
A capital structure is called an efficient capital structure if the total risk of the firm is at a minimum level. The excessive use of debt should be avoided to keep the financial risk of the company at a minimum level. Again if a firm is having higher business risk then it should try to minimize its financial risk.
Factor # 2. Control:
The decision making power of the firm lies in the hands of equity shareholders. If they do not wish to dilute their control then they may prefer to raise the additional funds through issue of debt instead of issuing equity shares. The equity shareholders have their representatives in the ‘Board of Directors’.
All the policy decisions are taken by equity shareholders in general meetings. Debenture holders and preference shareholders are not allowed to participate in decision making. If the debentures are redeemable after sometime then there is no fear of dilution of control but if the debentures are convertible then it will dilute the control of the existing equity shareholders.
Even preference shareholders are not eligible to participate in decision making unless and until they are cumulative preference shareholders and dividend has not been paid by the company for the last two consecutive years.
In case of non-cumulative preference shares, shareholders have a right to vote if their dividends are unpaid for the last two financial years preceding the date of meeting.
Lenders of long-term loans are eligible to participate in the decision making if they are financial institutions or banks who impose a condition that their representative is placed on the Board of Directors.
If a company wants to get listed at stock-exchange then it should offer a minimum prescribed amount of equity shares to the public. If the shareholders are more interested in increasing their EPS then the firm should go for financing through borrowing. Hence all these factors play an important role in designing a desired capital structure.
Factor # 3. Profitability:
A capital structure should be designed in such a way so that it generates maximum profits to the firm. Therefore, maximum debt financing should be opted to increase the returns available to equity shareholders. If the returns on assets are more than the cost of raising debt then the use of financial leverage may raise the profits of the firm.
Factor # 4. Cost of Capital:
A firm should be able to generate enough earnings to meet its cost of capital and to finance the future growth plan of the firm. If a firm is in a high risk class i.e. business and financial risk of the firm are very high then it will not be possible for the firm to raise additional funds at a low cost.
Although debt is a cheaper source of finance but excessive use of debt i.e. increased gearing will increase the expectations of the equity shareholders as they perceive use of excessive debt more risky. Generally, the cost of debt is lower than the cost of equity as debt holders are assured of receiving fixed payment on scheduled time.
However, firms with higher levels of debt in their capital structure are sometimes unable to meet their fixed interest payments and as a result the firm may become bankrupt.
Hence, the specific costs of different sources of funds and the resultant overall cost of capital is also an important consideration in designing an appropriate capital structure. A capital structure having minimum overall cost of capital can be regarded as most appropriate.
Factor # 5. Trading on Equity:
The basic objective of financial management is the maximization of shareholder’s wealth. The shareholders’ wealth is increased if the after-tax earnings of the firm are increased. A firm may raise funds either by issue of shares or debentures.
Debentures carry a fixed rate of interest and preference shareholders also carry a fixed dividend but the payment of dividend to equity shareholders depends upon the profitability of the company.
If the returns on total capital employed i.e. ROI is more than the cost of debt or rate of dividend on preference shares, it is called trading on equity. The use of trading on equity increases the earnings available to equity holders by using low cost debts.
But there are few limitations to the use of trading on equity, which are as follows:
(i) Trading on equity can be done if the company’s returns on investments are more than the payment of fixed interest and preference dividend.
(ii) Debt is a cheaper source of finance but excessive use of debt in the capital-structure will raise the level of financial risk, the lenders will also demand a higher rate of interest if the company wants to borrow further. Borrowing becomes costlier beyond a certain level of debt-content in the capital structure.
(iii) Trading on equity is beneficial if the company’s earnings are stable. Both interest on debentures and preference dividend are a fixed burden on the company. Company has to make the payment of interest whether it earns profits or not. Therefore, stable earnings are required.
Factor # 6. Flexibility:
Capital structure should be such that it can be easily manoeuvred to meet the requirements of changing conditions. Debt can be easily raised and paid off as and when required. The debt-capital brings in more flexibility with it Equity capital can also be reduced by buy-back arrangements.
Factor # 7. Attitude of the Investors:
There are two types of investors, one who takes risk and others who averts risk. Equity capital is best suited for those who can take risk and who are bold enough to bear the high risk. Debentures are suitable for those who are very cautious. Therefore, it would be appropriate for the companies to issue different categories of securities.
Factor # 8. Nature of Business:
Companies having stable earning can issue debentures or preference shares as they can bear the burden of fixed interest and fixed dividend. Even companies having a monopoly over products or public utility companies have adequate profits to pay the fixed interest and dividend. Companies which do not have regular and stable earnings can raise their finances through equity capital
Factor # 9. Size of the Company:
Large companies having diversified businesses need more funds and this need of huge funds can be met through borrowings and public issue of equity shares. Such companies are less risky as they have a broad base of owner’s funds, therefore investors rely upon these companies and they prefer to invest in big business houses.
Small companies rely on owner’s funds for financing. It becomes difficult for them to raise funds from the market as they do not have a market standing.
Factor # 10. Purpose:
Purpose of financing should be considered while deciding the sources of financing. Long-term funds are used for financing long-term projects. Debentures, bank loans etc. are used to finance short-term-projects. If the funds are required for a productive purpose e.g. funds are used to buy a plant which will immediately generate revenues, then the company can raise the funds through issue of debentures.
However, if the funds are needed to finance an unproductive activity like a welfare activity, it would be better to raise the funds through internally generated funds or equity shares.
Factor # 11. Time of Issue:
While deciding about the capital structure and the type of security to be raised, it is important to consider the time of issue i.e. whether it is a boom or recession period. Public offering should be made at a time when the state of the economy and the capital market is ideal to provide the funds.
The monetary and fiscal policies pursued by the government are very important. During the recession period, the government wants to boost the economy, therefore it offers cheap money whereas during the time of inflation, the government follows the policy to curtail the money supply.
Therefore, the company has to evaluate the various alternatives in the light of market conditions. The company will finance its projects with borrowed funds if the management feels that borrowed funds will become costlier in near future and if the rate of interest on borrowed funds is expected to decline in the near future, the company will wait for interest rate to come down and then use the borrowed capital.
Sometimes, we have to finance our projects by using costlier funds. It happens when the demand for that particular project or product is very high and early return to flow of funds is higher. The increase in the rate of return is more than the increase in the cost of finance.
Therefore, it is not always advisable to go for cheapest finance but the finance should be used when it is useful for the company. Time-analysis is not the only basis for deciding about the source of finance but other factors like legal requirements, company policy about future capital structure is also to be taken care of while deciding about the capital structure.
Factor # 12. Tax Planning:
Tax planning is likely to have a significant bearing on capital structure decisions. Interest on debt capital is deductible as an expense and reduces the tax liability. The tax saving on debt reduces the cost of debt. The increased use of debt in the capital structure brings higher earnings for equity shareholders.
However, dividend payment does not save any tax, rather the company has to pay the corporate dividend tax on the amount of dividend declared. The floatation cost of debt and equity are deductible over a period of 10 years. If the floatation cost is incurred during pre-commencement period then it is to be capitalised. Thus, tax is an important consideration for deciding the capital structure.
Factor # 13. Debt-Equity Ratio of the Industry:
Comparison has to be made with the debt-equity ratio of the company with other companies having the same business risk in the industry. Industry standards provide a useful benchmark.
If the debt-equity ratio of the firm is not in line with the debt-equity ratio of the industry then it would mean that the company is either very conservative or very aggressive in taking risk. However, such comparison should be made to check whether the company is on right track or not
Factor # 14. Consulting Lenders and Bankers:
Another useful consideration to decide the capital structure is taking advice from investment bankers and lenders. Since these analysts are in this business for a long time, they acquire expertise and have access to the information regarding the value of different securities of a large number of companies in the market.
Therefore, their guidance and opinion is important as they are going to provide funds in the future. Their preference will help the company to issue the desired form of securities.