Factor Determining Capital Structure

The following internal factors must be considered while determining the capital structure of a company:-

I. Internal Factor

II. External Factor


The following internal factors must be considered while determining the capital structure of a company:-

1. Nature of Business: The capital structure of a company is considerably affected by the nature of its business. Public utilities, extractive, financing, and merchandising enterprises are more stable in their earnings and enjoy a greater degree of freedom from competition than industrial concerns. Thus, companies having stable earnings can afford to raise funds through sources involving fixed charges, while other companies have to rely heavily on equity share capital.


2. Regularity and Certainty of Income: Capital structure is also affected by the regularity and certainty of income. If the company expects sufficient regular income but it is hopeful that its average earnings for a few years may be equal to or in excess of the amount of dividend to be paid on such preference shares. If a company does not expect any regular income in the future, it should never issue any type of securities other than equity shares.


 3. Desire to Control the Business: The shareholder’s or promotors' desire to control the affairs of the company directly affects its capital structure. If the control of the company is to be retained within a few hands, a large proportion of funds is raised by the issuance of non-voting rights securities, such as debentures and preference shares.


4. Future Plans: The capital structure of a company is also affected by its development and expansion programs in the future. For this purpose, the amount of authorized capital is kept higher so that the requisite amount may be raised at the time of need. At the outset, the company collects capital by issuing equity shares. Thereafter, capital structure is devised in accordance with the future development and expansion programs and the requisite capital is raised by issuing preference shares and debentures.


5. Purpose of Finance: An important factor determining the type of capital to be raised is the purpose for which capital is required.   If funds are needed for some productive activity that will directly add to the profitability of the company, capital may be raised by issuing securities bearing fixed charges like preference shares and debentures. Conversely, if funds are needed for such purposes as betterment, maintenance, etc., which do not directly add to the earnings of the company, retained earnings or equity share capital will be the better source of financing.

6. Attitude of Management: The capital structure of a company is also affected by the attitude of the management. Management varies to skill, judgment, experience, temperament, and motivation. It evaluates the same risks differently and its willingness to employ debt capital also differs. The influence of capital structure is, therefore, equal to the age, experience, ambition, confidence, and conservativeness of the management.


7. Trading on Equity: Trading on equity refers to the regular use of borrowed capital as well as equity capital in the conduct of a company's business. In other words, when a company employs borrowed capital including preference share capital in such a way as to increase the rate of return on equity shares, it is said to be trading on equity. Obviously, if the fixed rate of interest on borrowed capital or dividend on preference shares is lower than the general rate of earnings of the company, the equity shareholders will have an advantage in the form of an additional dividend. Trading on equity, therefore, implies the presence of favorable financial leverage in the company's capital structure. Thus,   a company would prefer to issue debentures or preference shares having a rate of interest or dividend lower than the general rate of its earnings.


8. Debt Capacity and Extent of Risk: The use of borrowed capital becomes risky for the company after a certain extent because it would lead to an increase in the fixed liability of interest payment adversely affecting the company's income and reducing its liquidity. In the long-run, excessive use of borrowed funds also endanger the solvency of the company. A high debt-equity ratio is risky for companies with uncertain, irregular, and inadequate earnings. So, the determination of the debt-equity ratio of such companies should be in accordance with their debt capacity.


9. Cost of Capital: Cost of capital is an important determinant of the capital structure of a company. Since cost of capital directly influences the profitability and general rate of earnings, a company must select such sources of finance as would entail the incurrence of the least cost. Generally, a company must raise capital funds by borrowings when the rate of interest is low and by issuing equity shares when the rate of earnings and share prices are high.


10. Capital Gearing Ratio: Equity shares are the foundation of the capital of a company. The ratio of fixed cost-bearing capital to variable cost-bearing capital is called 'capital gearing'. When the ratio of equity shares (i.e., variable cost-bearing capital) is low in the total capital structure, it is called 'High Gearing'. Conversely, when the ratio of equity shares in the total capital structure of a company is high, it is called 'Low Gearing'. Stability in equity share price and goodwill of a company depends on adequate capital gearing. A high capital gearing ratio encourages speculation in shares of such a company and the market price of shares continues to fluctuate. It is, therefore, necessary for the promotors to determine the ratio of fixed-cost securities (preference shares and debentures) and fluctuating-cost securities (equity shares) very carefully.


11. Timing and Duration of Finance: If capital funds are needed for the short term, they must be arranged through borrowings. Funds raised by issuing fixed-cost securities (debentures and redeemable preference shares) can be repaid as soon as the company's financial position becomes strong. On the other hand, long-term capital funds must be raised by issuing equity shares.


12. Flexibility and Simplicity: The capital structure must be flexible to increase or decrease the funds as per the requirements of the enterprise.   Excessive dependence on fixed-cost securities makes the capital structure rigid because of the fixed payment of interest of dividends. Thus, these sources should be kept in reserve for emergency and expansion purposes. The capital structure must also be simple, so that financial crisis may be avoided.


The following external factors must be considered while determining the capital structure of a company:-

1. Nature and Kind of Investors: The success of capital structure largely depends upon the psychological conditions of different types of investors. An ideal capital structure is one that suits the needs of different types of customers. Some investors prefer the security of investment and stability of income, while others prefer higher income and capital appreciation. Thus, shares and debentures should be issued in accordance with the tastes and preferences of all types of customers.


2. State of Capital Market: Conditions of the capital market have a direct bearing on the capital structure of a company. In times of depression, the rate of dividends on equity shares comes down and the possibilities of profit are the least. In such a situation the investors would prefer to invest in debentures and not in equity shares. Thus, debentures should be issued in times of depression. Conversely, during a boom period when people have sufficient funds, any type of security can be issued to raise the requisite funds. Hence, equity shares should be issued during the boom period.


3. Cost of Capital: The issue Capital structure of a company is also affected by the cost of the capital issue. The capital structure should, therefore, be designed in such a way as to minimize the commission payable to brokers, middlemen, and underwriters or the discount payable on the issue of debentures and bonds. Thus, a company should raise funds by issuing different types of securities in such a  way as would minimize the cost of the capital issue.


4. Present Statutes and Rules: Capital structure is also influenced by the statutes and rules prevailing in the country. For instance, if a company's income is taxed at a higher rate then directors would prefer to issue debentures because the amount of interest payable to debenture holders is deducted while computing the company's total income. It is a statutory deduction whereas a dividend is not an accepted deduction. It is evident from the foregoing discussion that devising of a sound capital structure is a difficult task, and requires utmost care on the part of promotors. Thus, while devising the capital structure of a company the above important factors should be borne in mind.

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