What are the different factors that a finance manager needs to consider while taking decisions regarding his/her firm’s capital structure. Explain each of
these factors in detail.
Capital structure of a company refers to the composition of long-term sources of funds, such as-ordinary shares, preference shares, debentures, bonds, long-term debts etc. In other words, it refers to the kind and proportion of securities for raising long-term funds. It implies the determination of form or make- up of a company's capitalisation. Some authors use capitalisation and capital structure interchangeably. However, capitalisation merely refers to the determination of the amount of capital needed for successful business operations, whereas capital structure is concerned with the determination of proportion of different sources of long-term funds in the capitalisation of a company. It is, therefore, evident that `capitalisation' and `capital structure' are the two different aspects of financial planning.
The following factors govern the capital structure of a company:
(1) Trading on Equity. A Company earns the profits on its total capital (borrowed
and owned). On the borrowed capital (including preference capital) company pays interest or dividend at a fixed rate. If this fixed rate is lower than the general rate of earnings of the company, the ordinary shareholders will have an advantage in the form of additional profits. This may be referred to as trading on equity. This `trading on equity' is an arrangement under which a company makes use of borrowed funds including preference capital bearing a fixed rate of interest or dividend in such a way as to increase the rate of return on equity shares. The rate of dividend on equity shares could not, otherwise go beyond the general rate of earning if whole of its capital is raised by the issue of equity shares, shares bearing a rate of interest/dividend below the general rate of return. Company will also have an advantage in the saving of income tax as interest paid on debentures is a deductible expense. This double advantage tempts the management to trade on equity.
(2) Desire to Control the Business. Quite often, the promoters want to retain the control of the affairs of the company. They raise the capital from the public by issuing different types of securities is such a way as to retain the control of whole or substantially the whole of the affairs of the company with them. For this purpose, they raise a large proportion of funds by the issue of debentures and preference shares. Debentureholders and preference shareholders are usually not given any voting right as enjoyed by the equity shareholders. A majority of equity share capital is, therefore, held by the promoters and their near-relatives as only the equity shareholders enjoy the voting right in the conduct of the affairs of the company. Thus, the company collects its requirement of funds from the public, though the control rests with the promoters.
(3) Nature of Business. Nature of business must be taken into account while designing the financial plan and n have a determining the capital structure. A manufacturing company may structure from merchantising, financing, extractive or public utility concerns. These enterprises differ in regard to the amount of investment, risk of failures involved, trade cycles and freedom from competition. These, differences enable one type of business issue securities which are not profitable to other business. So, public utility concern may enjoy advantages of fixed interest securities like bonds and debenture because of their monopoly and stability of income. But, on the other hand, manufacturing concerns do not enjoy such advantages and rely to a great extent on equity share cap
(4) Purpose of Financing. The purpose for which funds are being raised must be taken into account at the time of devising financial structure of a company. If funds are raised for betterment expenditure, it is quite apparent that it will add nothing to the earning capacity of the company. Such expenditure may be incurred either out f funds raised by issue of shares or still better out of retained earnings but, in no case, out of borrowed funds. On the other hand productive projects may be financed out of borrowings also. Borrowings should never be used to meet out losses unless they are caused by paucity of funds.
(5) Period of Finance. Normally funds which are required for a short time say for 5 to 10 years should be arranged through borrowing because these can easily be repaid as soon as company's financial position improves. In such cases, shares should not be issued because, share capital except redeemable preference share capital cannot be repaid during the life-time of the company even if company is in possession of its own funds. Issue of redeemable preference shares, too should be avoided in such cases as it requires certain legal formalities. On the other hand, if funds are required permanently or for a fairly long time, issue of ordinary shares should be preferred.
(6) Elasticity of capital structure. The capital structure should be as elastic as possible so as to provide for expansion for future development or to make it feasible to reduce the
capital when it is not needed. Too much dependence on debentures and preference shares from the very beginning makes the capital structure of the company rigid because of payment of fixed interest or dividend. These sources should be kept in reserve for emergency or for expansion purposes. Of course, expansion of funds is not a problem and it can very easily be done either by issue of fresh shares or debentures or by obtaining loan from financial institutions or from public but contraction of capital is really a problem. To make it feasible, debentures which may be paid off after or within a fixed period as per terms of issue can be issued.
(7) Nature of Investors. An ideal capital structure is that which suits the needs of different types of investors having varying financial status and varying psychologies.
Some investors who prefer security of investment and stability of income usually go in for debentures. Preference shares will be preferred by those who want a higher and stable income with enough safety of investment. Equity shares will be taken up by those who are ready to take risks for higher income and capital appreciation. Those who want to acquire control over the affairs of the company like equity shares.
Security with different denominations should be issued to suit the financial status of different persons in order to secure subscription from people in different strata of society- rich, middle, and lower clasess.
(8) Market Conditions. Conditions of capital market have an important bearing on the capital structure of the company because investor is very often influenced by the
general mood or sentiment of the capital market although his own mood or sentiments guide him to invest his funds. For example, in times of depression, investor will look more for safety than to income and will be willing to invest in debenture and not in equity shares. During boom period, when people have plethora of funds, any type of security can be sold easily hence equities can have a better market. The management while designing the capital structure of the company must watch the mood or sentiment of the capital market.
(9) Legal Restrictions. Every company has to comply the law of the country regarding the issue of different types of securities. Therefore, hands of the management are tied by these legal restrictions. For example in India India
(10) Policy of Term Financing Institution. If financial institutions offer credit to the
industry on strictly restrictive terms and adopt harsh policy of lending, the management will give more weightage to manueverability principle and abstain from borrowing from these institutions and will arrange capital from other sources. On the other hand, if the financial institutions provide credit on soft terms, the firm will follow cost principle in obtaining funds from these institutions on easy terms
(11) Stability of Earning or Possibilities of Regular and Fixed Income. The stability of capital structure of a company very much depends upon the possibility of regular and fixed income. Mr. A. S. Dewing has propounded three principles in this regard.
(a) If company expects sufficient regular income in future, debenture should be issued.
(b) Preference shares may be issued if company does not expect 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.
(c) If company does not expect any regular income in future, it should never issue any type of securities other than equity shares.
The above factors are important to bear in mind to devise the capital structure of a company.
(12) Trends in Capital Market. Capital market conditions determine not only the
types of securities to be issued, but also the rate of interest on debentures, fixed rates of
dividends on preference shares and the prices of equity shares. When investment funds decline better yields and protection for preference shares are demanded. When such funds increase, preference shares may be sold on terms more favourable to the issuing company.
(13) Cost of Capital and Availability of Funds. The exact form of financing is, at
times, the result of the study of comparative costs of various types of financing in relation to the risk involved and the availability of various alternative forms of financing. In a certain situation, debentures may be issued because of their cheapness and availability despite the danger of fixed obligaiton.
(14) Prevailing Financial Statutes. Government may also influence the scheme of
company finance in more ways than one, for example, through regulation and taxation policies, etc. This factor is of special significance in Indian India companies the rates of income tax are the highest in the world. High rates of corporation taxes put a premium on debt financing as compared with equity or preference shares, because while interest on debentures is allowed as a deduction from taxable income, the payment of dividend is not, (advantage of Tax Shield).
(15) Assets Structure. Asset structure also influences the sources of financing in several ways. Firms with long- lived fixed assets, specially when demand for the output is relatively assured can use long-term debts. Firms whose assets are mostly receivables and inventory whose value is dependent on the continued profitability of the individual firm can rely less long-term debt financing and more on short-term funds.
(16) Attitude of management. Management varies in skill, judgment, experience, temperament and motivation. It evaluates the same risk differently and its willingness to employ debt finance also differs. The capital structure, therefore, is to a large extent, equally influenced by the age, experience, ambition, confidence and conservativeness of the managements.
(17) Lender's Attitude. Sometimes, the lender's attitude is also an important determinant of capital structure. In the majority of cases, the firm's management discusses its capital structure with lenders and gives much weight to their advice. But where management is the confident of future, it may use leverage beyond norms for the industry.
(18) Fiscal Incentives and Tax Concession. Incentives and tax concessions being provided by the government to various types of industrial units like relaxation of security margin, 15% subsidy by the Government, of repayment period extension beyond 10 years, gestation period 2 years, reduction in application to the extent of 50% in application is made for the promotion in background areas also affect the capital structure.
(19) Advice given by Financing Agencies. Such agencies are specialised in tendering expert financial advice concerning the capital structure of a firm. Their advice should be
given due weight and consideration in financial plan of the concern.
Thus, we see, the determination of a suitable pattern of capital structure requires a thorough consideration of a large number of factors. There can be no ideal pattern of capital structure for all companies even in the same industry. So each company has to be studied as an individual case.
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