What is capital structure? Discuss the determinants of capital structure.

What is capital structure? Discuss the determinants of capital structure.

Ans:        Capital structure: It represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, etc. Any earned revenue and capital surpluses are included.

Capital Structure Planning: Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. The small companies often do not plan their capital structure. The capital structure is allowed to develop without any formal planning. These companies may do well in the short-run, however, sooner or later they face considerable difficulties. The unplanned capital structure does not permit an economical use of funds for the company. A company should therefore plan its capital structure in such a way that it derives maximum advantage out of it and is able to adjust more easily to the changing conditions. Instead of following any scientific procedure to find an appropriate proportion of different types of capital which will minimise the cost of capital and maximise the market value, a company may just either follow what other comparable companies do regarding capital structure or may consult some institutional lender and follow its advice.

Theoretically, a company should plan an optimum capital structure in such a way that the market value of its shares is maximum. The value will be maximised when the marginal real cost of each source of funds is the same. In general, the discussion on the issue of optimum capital structure is highly theoretical. The determination of an optimum capital structure in practice is a formidable task, and we have to go beyond the theory. That is why, perhaps, significant variations among industries and among' different companies within the same industry regarding capital structure are found. A number of factors influence the capital structure decision of a company. The judgement of the person or group of persons making the capital structure decision plays a crucial role. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. These factors are highly psychological, complex and qualitative and do not always follow the accepted theory. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. You might have become interested in identifying some of the important factors which influence the planning of the capital structure in practice. However, before we discuss these factors let us examine the features of an appropriate capital structure in the next section.

Determinants of capital structure: capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Once a company has been formed and it has been in existence for some years, the financial manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure: Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance.

The factors to be considered whenever a capital structure decision is taken are: (i) Financial Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let it’s briefly explain these factors.

(i)Financial Leverage or Trading on Equity: The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known as financial leverage or trading on equity. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners' investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders' equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (BPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm's capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans.

(ii) Cost of Capital: Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimise the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest, whether it makes profits or not. For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to minimise the overall cost of capital, a company should employ a large amount of debt.

(iii) Cash Flow: One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm's ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. If a company is not able to generate enough cash to meet its fixed obligations, it may have to face financial insolvency. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable.

(iv) Control: In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. The existing management team may not only what to be elected to the Board of Directors but may also desire to manage the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares, there is a risk of loss of control. This is not a very important consideration in case of a widely held company. The shares of such a company are widely scattered. Most of the shareholders are not interested in taking active part in the company's management. They do not have the time and urge to attend the meetings. They are simply interested in dividends and appreciation in the price of shares. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. Maintaining control however could be a significant question in the case of a closely held company. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital.

(v) Flexibility: Flexibility means the firm's ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds.

(vi) Size of the Company: The size of a company greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure.

(vii) Marketability: Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favours debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary₄shares to raise finances.

(viii) Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner's capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies.

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.

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, Banking companies  are not allowed to issue any type of securities except equity shares under the Indian Banking Companies Act. Again, under control of Capital Issues Act in India has fixed 4 : 1 ratio between debt and equity and 3 : 1 between equity and preferred stock. Within this overall framework, the management should strive towards capital structure.

(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.