Learn about the factors one should keep in mind while deciding capital structure of the company.
Some of the Inter Factors affecting the capital structure decisions of a company are: –
1. Financial Leverage 2. Risk 3. Growth and Stability 4. Retaining Control 5. Cost of Capital 6. Cash Flows 7. Flexibility 8. Purpose of Finance 9. Asset Structure.
And some of the External Factors affecting the capital structure decisions of a firm are:-
1. Size of the Company 2. Nature of Industry 3. Investors 4. Cost of Floatation 5. Legal Requirements 6. Period of Finance 7. Level of Interest Rate 8. Level of Business Activity 9. Availability of Funds 10. Taxation Policy 11. Level of Stock Prices
Additionally, some of the general factors in this regard could be summed as:-
1. Control 2. Risk 3. Income 4. Tax Consideration 5. Cost of Capital 6. Trading on Equity 7. Investors’ Attitude 8. Flexibility 9. Timing 10. Legal Provisions 11. Profitability 12. Growth Rate 13. Government Policy 14. Marketability 15. Company Size 16. Maneuverability 17. Financing Purpose
Learn about the Factors Affecting Capital Structure Decisions of a Firm, Business and Company
Factors Affecting Capital Structure Decisions – Top 17 Factors
In reality the following factors have great practical implications for capital structure:
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 Board of Directors. 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 risk are considered.
A firm with high business risk prefer to have low levels of debt, since the volatility of its earnings is more. A firm with low level of business risk can have higher debt component in capital structure, since the risk of variations in expected earnings is lower.
The higher proportion of debt increases the financial risk 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 levels 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 depress 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.
Factor # 5. Cost of Capital:
Cost of different components of capital will influence the capital structuring decisions. A firm should posses 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 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.
Factor # 6. Trading on Equity:
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 charging 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 exist.
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 lot of legal provisions.
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 of interest in investing. Then the firm is to rely in 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 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, increase in lending rates may cause the companies to raise finances from 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 small capital base will rely more on owner’s funds and internal earnings. But large companies have to depend on 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 Affecting Capital Structure Decisions: Internal and External Factors
I. Internal Factors:
1. Financial Leverage:
The use of fixed bearing securities, such as debt and preference capital along with owners’ equity in the capital structure is described as ‘financial leverage’ or ‘trading on equity’. This decision is most important from the point of view of financing decisions.
By having debt and equity in the capital mix, a company will have an opportunity of deploying certain amount of debt (instead of whole equity capital) with an intention to enjoy the benefit of reduction in the percentage of tax (as interest is debited to Profit and Loss A/c). The benefit so enjoyed will be passed on to the equity shareholders in the form of high percentage of dividend.
If the assets are financed, through the debt, it yields higher return than the cost of debt. Earnings per share increase without an increase in the owner’s investment. The earnings per share also increases when the preference share capital is used to acquire assets. (If r > kp) (r = return on investment and kp = cost of preference share capital).
The effect of debt in capital structure is reflected in earnings per share on the following grounds:
(i) Cost of debt is usually lower than the cost of preference share capital.
(ii) Interest period on debt is deductible under Income Tax Law.
Therefore, financial leverage is an important consideration in planning the capital structure of a company. The most popular method of examining the impact of leverage is to analyse the relationship between Earnings per Share and various levels of Earnings Before Interest and Taxes under different methods of financing. EBIT — EPS (Earnings before Interest and Taxes – Earnings Per Share) analysis is an important analytical tool at the disposal of a finance manager to get an insight into the firm’s capital structure.
2. Risk:
Ordinarily, debt securities increases the risk, while equity securities reduces it, risk can be measured to some extent by the use of ratio, measuring, gearing and time — interest earned. The risk attached to the use of leverage is called “Financial Risk”. Financial risk is added with the use of debt because of the increased variability in the shareholder’s earnings and threat of insolvency. A firm can avoid or reduce the risk, if it does not employ debt capital in the capital mix.
But, it reduces the returns to equity shareholders too. Hence a finance manager must employ the debt capital in such a way that, the benefit of that should maximise the returns to equity shareholders. However, in the long run EPS alone will not be considered as a determinant factor for structuring the capital. Wealth maximisation concept should be kept in mind.
3. Growth and Stability:
In the initial stages, a firm can meet its financial requirements through long-term sources, particularly by raising equity shares. Once the company starts getting good response and cash inflow capacity is increased through sales, it can raise debt or preference capital for growth and expansion programmes of the company.
Ploughing back of profits will also be used as a source, which provides flexibility and less dependence on the outsiders’ funds. The firm with stable sales can employ a high degree of leverage as they will not face difficulty in meeting their fixed commitments. The company which is having high sales and having the capacity of generating more sales revenue will opt for more amount of debt for their financial requirements.
The fixed charges of these instrument can be easily paid by such revenue will opt for more amount of debt for their financial requirement. The fixed charges of these instrument can be easily paid by such revenue and can increase the returns to equity shareholders.
In contrast to this, a company which is having less sales revenue must reduce its burden towards debt, because of the inability of the company to pay interest on debt. Otherwise, it takes the company directly liquidation. Hence the policies of growth and stability will directly influence the capital structure.
4. Retaining Control:
The attitude of the management towards retaining the control over the company will have direct impact on the capital structure. If the existing shareholders want to continue the same holding on the company, they may not encourage the issue of additional equity shares. Fresh issue of equity share reduces the interest and holding over the company.
The divisible profits percentage of such company will also come down. In the long run it affects the market value of the shares. Hence, in the normal practical situation, the existing equity shareholders directs the management to raise the additional source only through debentures or preference shares.
However, issue of debentures and preference shares also be influenced by the reputation that is enjoyed by the company. If the creditworthiness of a firm is good, it can raise the funds according to the desire of the existing shareholders.
5. Cost of Capital:
The cost of capital refers to the expectation of suppliers of funds. The objective of knowing the cost of capital is to increase the returns on investments, so that, a firm should earn sufficient profits to repay the interest and instalment of principal to the lenders. Hence, it is also known as the maximum rate of return of a firm earn on its investments, so that the market value of equity shares of the company does not fall.
In the real life situation, a finance manager evaluate the cost of equity by considering the percentage of dividend and the capital gains expected by equity shareholders. The cost of debenture is assessed by taking the assured percentage of dividend. Therefore, different type of sources of funds will have different types of costs. Debt is a cheaper source of fund when compared to other sources.
The return on total capital employed can be maximised by minimising total average cost of capital. Careful decision has to be made in selecting the size of debt, because, beyond a particular ratio (D:E) debt increases the risk of a firm. Hence cost of capital influences the capital structure.
6. Cash Flows:
Cash flow ability of a company will have direct impact of the capital structure. Cash flow generation capacity of a firm increases the flexibility of finance manager in deciding the capital structure. Cash generated by a company or availability of a continuous supply of cash increases the reputation of a company.
Cash flows permits the company to meet its short-term obligations. A firm will have the obligation to pay dividend to equity shareholders, interest to banker and debenture holders. Cash flow generating capacity of a company helps in meeting this commitment. Sound cash flows facilitates the finance manager in raising funds through debt.
7. Flexibility:
Flexibility means the firms’ ability, to adopt its capital structure to the needs of changing conditions, its capital structure should be flexible, so that without much practical difficulties, a firm can change the securities in capital structure. Redeemable preference shares and redeemable debentures increases the flexibility of capital structure, as it can be redeemed at the discretion of the company.
The degree of flexibility in the capital structure mainly depends on:
(i) Flexibility in fixed charges,
(ii) Restrictive covenants in loan agreements,
(iii) Terms of redemption and
(iv) The debt capacity.
(i) Flexibility in Fixed Charges:
Different securities will have different fixed commitments of interest or cost. Interest cost on the borrowings will have permanent obligation on the company. Obligation of dividend on preference share is not permanent, it becomes a commitment only when a company earns profit. The nonpayment of preference dividend can cause a set back to the company’s reputation, but, it does not result in insolvency.
The dividend on equity shares is not at all a forced obligation. As a policy, a company may give dividend regularly but it is free to retain certain amount of profit as ‘retained earnings’. This can be used as a source of funds for expansion and diversification programmes. Thus, from the fixed charges of a firm, it can decide the ratio of debt to equity mix. Hence capital structure is influenced by the fixed charges of different securities.
(ii) Restrictive Covenants:
Restrictive covenants are commonly included in long-term loan agreements and debentures. These restrictions curtails the freedom of a company in dealing with financial matters and put it in an inflexible position. Covenants in loan agreements may include restrictions or to raise additional external finances.
A company may also be required to maintain a certain amount of working capital or to maintain certain ratios, such as debt equity restrictions may be quite reasonable from the point of view of creditors as they are meant to protect their interests; but they reduce the flexibility of company to operate freely and may become burdensome if conditions change. Therefore, a company should ensures while issuing debentures or accepting other forms of long-term debt that a minimum of restrictive clauses, that circumscribe its financial action in future, are included in debt agreements.
(iii) Terms of Redemption:
A company must have maximum flexibility in its capital structure to maximise the returns on investment. This can be maintained by having redeemable preference share and debenture of the firm’s discretion. This helps the company to replace different securities easily. When a firm has excess cash, it can repay or redeem preference shares and debentures. If inadequacy in cash arises. It can issue additional securities. Hence, terms of redemption influences the capital structure.
(iv) The Debt Capacity:
The flexibility of the capital structure also depends on the company’s debt capacity. If a firm has less amount of debt with more amount of equity capital, it has the potentiality of raising debt finance whenever it requires. The unused debt capacity facilitates flexibility in the capital structure. Therefore cost and benefit of each ‘mix’ should be evaluated before taking a final decision on the ‘Capital Structure’.
8. Purpose of Finance:
The purpose of finance is another factor that influence the capital structure. If a firm is engaged in business transactions, it can make use of Debt and Equity mix or can enjoy leverage benefits. If funds are needed for non-profit organisations to build social welfare measures, it can meet its requirements only through equity capital. For an existing company, funds may be required for expansion or diversification. It may be financed through retained earnings, debentures or preference capital. Hence purpose of business influences the capital structure.
9. Asset Structure:
Funds are needed to make investments on fixed assets and current assets. Fixed assets investments can be met by long-term sources, viz., through the issue of equity, debentures or preference. A portion of current asset investments are also financed by long-term sources. Short-term sources are used for meeting the working capital requirement. Hence Asset Structure (both fixed assets and current assets) influences the capital structure.
II. External Factors:
1. Size of the Company:
If the size of business is small, the requirement of finance is too little. If the size of the business of a firms is large, large amount of capital is required. If a firm plans to raise smaller amount of capital, it selects only few securities in its capital structure. If it need more capital, number of different securities will be selected to raise funds with more flexibility in the capital structure.
2. Nature of Industry:
The nature of industry, method of production, type of product, etc., will also influence the capital structure. A public utility concern which has a unique support and identify form the State and Central Government (Food Corporation of India, Mysore Power Corporation) can raise funds through preference shares or debentures.
A capital-intensive industry engaged in manufacturing iron and steel products may have high equity and less debt capital. A trading company, which has less asset structure, has to depend mainly on equity or preference capital to meet their capital requirement.
3. Investors:
In the recent past, the behaviour of the investors have changed. The statistics of public issues in the primary market indicates more fluctuations in the flow of funds.
Now the investors are cautious over the investments. Political, socio-economic factors of the country made the investors to be very alert in their portfolio management. Hence, capital market is moving from equity to debt and debt to deep discount bonds. The finance manager must be careful in selecting the securities for capital structure.
4. Cost of Floatation:
The cost of floatation refers to the expenses a firm incurred during the process of public issues. Advertising, campaigning, printing of application forms, fees of merchant bankers, underwriting commission, brokerage, etc. The finance, manager has to evaluate such expenses with particular reference to each financial instrument. Cost of floatation of debt is comparatively less when compared to cost of floatation of equity. He should try to reduce this cost by: proper mix of debt and equity in the capital structure.
5. Legal Requirements:
The legal and statutory requirement of the government will also influence the capital structure. SEBI guidelines on investors’ protection, maintaining D:E ratio and current ratio, promoter contribution, etc., will have direct bearing on capital structure. Besides this, the monetary and fiscal policies of the government also affect the capital structure decision.
6. Period of Finance:
Funds are required for different period for different purposes. Short-term (1-3 years) funds are required to meet working capital requirements. Hence, it is raised through commercial banks (O.D, Cash Credit).
Medium-term finance (8-10 years) is required to meet expansion and diversification purposes and which can be raised through issue of preference or debenture capital. Funds are needed permanently for a company to meet its capital expenditure. This can be raised by issuing equity shares. Hence, period of finance will also influence the capital structure.
7. Level of Interest Rate:
The rate of interest will have a direct impact on borrowed funds. If the expectation of the banker or financial institution is more to get high percentage of interest, a firm can postpone the mobilisation of funds or can make use of retained earnings. Hence, it affects the capital structure.
8. Level of Business Activity:
When a level of business activity of a firm is raising, it requires more funds for expansion and diversification. The company may opt for raising additional funds through issue of debentures, preference share or it can borrow term loans. Hence, it affects the capital structure.
9. Availability of Funds:
The availability of money in the capital and money market will directly influence the company’s financial structure. Free flow of money in the economy encourages a corporate to raise funds-through securities without much difficulties. Hence, a finance manager has to study the flow and availability of funds before he decides about the capital structure.
10. Taxation Policy:
High corporate tax, high tax on dividend and capital gains directly influence the decision of capital structure. High tax discourages the issues of equity and encourages to issue more amount debt instrument, as the fixed charges on these securities, i.e., interest can be directly charged to Profit and Loss Account for income tax calculations. Hence, capital structure of a company is affected.
11. Level of Stock Prices:
If the general price level of stocks or raw materials are constant over a period of time, management prefers to invest such funds either through equity or preference capital, in other words, long-term or medium-term financing. If the prices are fluctuating too widely (impossible to predict), short-term source is the best alternative for investments.
Factors Affecting Capital Structure Decisions – Characteristics of Economy, Industry and Company
The principles determining the choice of different source of capital funds are antagonistic to each other. For example, cost principle supports induction of additional does of debt in the business which may not be favoured from risk point of view because with additional debt the company may run the risk of bankruptcy.
Similarly, control factor supports strongly for issue of bonds but maneuverability factor discounts this step and favours the issue of common stock. Thus, to design suitable pattern of capital structure for the company finance manager must bring about a satisfactory compromise among these conflicting factors of cost, risk, control and timing.
This compromise is to be reached by assigning weights to these factors in terms of economic and industrial characteristics and also in terms of specific characteristics of the company.
How significance of these principles is influenced by different factors are described below:
1. Characteristics of the Economy:
Any decision relating to pattern of capital structure must be made in the light of future developments which are likely to take place in the economy because the management has little control over the economic environment. Finance manager should, therefore, make predictions of the economic outlook and adjust the financial plan accordingly.
Tempo of business activity, state of capital market, state regulation, taxation policy and financial policy of financial institutions are some of the vital aspects of the economy which have a strong bearing on capital structure decision.
(a) Tempo of Business Activity:
If the economy is to recover from current depression and the level of business activity is expected to expand, the management should assign greater weightage to maneuverability so that the company may have several alternative sources available to procure additional funds to meet its growth needs and accordingly, equity stock should be given more emphasis in financing programmes and avoid issuing bonds with restrictive covenants.
(b) State of Capital Market:
Study of trends of capital market should be undertaken in depth since cost and availability of different types of funds is essentially governed by them. If stock market is going to be plunged in bearish state and interest rates are expected to decline the management may provide greater weightage to maneuverability factor in order to take advantage of cheaper debt later on and postpone debt for the present.
However, if debt will become costlier and will be scarce in its availability owing to bullish trend of the market, income factor may receive higher weightage and accordingly, the management may wish to introduce additional doses of debt.
(c) Taxation:
The existing taxation provision makes debt more advantageous in relation to stock capital in as much as interest on bonds is a tax deductible expense whereas dividend is subject to tax. Although it is too difficult to forecast future changes in tax rates, there is no doubt that the tax rates will be adjusted downwards.
In view of prevailing high corporate tax rate in India the management would wish to raise degree of financial leverage by placing greater reliance on borrowing.
The general debt equity ratio for medium and large scale projects is 2:1. Within this overall framework, the management should strive towards attaining appropriate capital structure.
(d) Policy of Term-Financing Institutions:
If financial institutions adopt harsh policy of lending and prescribe highly restrictive terms, the management must give more significance to maneuverability principle and abstain from borrowing from those institutions so as to preserve the company’s maneuverability in capital funds.
However, if funds can be obtained in desired quantity and on easy terms from the financial institutions it would be in fitness of things to assign more weight to cost principle and obtain funds from the institution that supplies cheaper funds.
2. Characteristics of the Industry:
(a) Cyclical Variations:
There are industries whose products are subject to wider variation in sales in response to national income. For example, sales of the refrigerators, machine tools and most capital equipments fluctuate more violently than the income. As against this, some products have low income elasticity and their sales do not change in proportion to variation in national income.
Non-durable consumer goods, inexpensive items like paper clips or items of habitual use are examples of such products which are fairly immune to changes in level of income
The management should attach more significance to maneuverability and risk principles in choosing suitable source of funds in an industry dealing in products whose sales fluctuate very markedly over a business cycle so that the company may have freedom to expand or contract the resources used in accordance it business requirements.
Further, the management would be averse to secure loan for additional funds since this would go against the interests of the owners and-the company would run the risk of bankruptcy during the lean years which could spell depth knell of the company.
(b) Degree of Competition:
Public utility concerns are generally free from inter-industry competition. Accordingly, profits of these concerns in the absence of inroads of competitors are likely to be relatively more stable and predictable. In such concern the management may wish to provide greater weightage to cost principle to take advantage of financial leverage.
But where nature of industry is such that there is neck to neck competition among concerns and profits of the business are, therefore, not easy to predict, risk principle should be given more weightage. Accordingly, the company should insist on equity stock financing because it would incur the risk of not being able to meet payments on borrowed funds in case bonds are issued.
(c) State Legislation:
Decision to make up capitalisation is subject to state control. For example, debt-equity norm has been prescribe as 4:1 and equity and preferred stock norm as 3:1. The equity capital to be subscribed in any issue to the public by promoters should be less than 25 per cent of the total issue of equity capital for amounts up to Rs. 100 crore and 20 per cent of the issue for amounts above Rs. 100 crore.
Within this parameter, the management should strive toward attaining suitable capital structure.
(d) Policy of Term-Financing Institutions:
The management should also take into consideration policy of the financial institutions. For instance, the general debt-equity norm prescribed by the Indian financial institutions for providing assistance to medium and large scale projects is 1:5:1. The promoters are required to contribute a minimum of 20-25 per cent of the cost of the project.
3. Characteristics of the Company:
(a) Size of Business:
Smaller companies confront tremendous problem in assembling funds because of their poor creditworthiness. Investors feel loath in investing their money in securities of these companies. Lenders prescribe highly restrictive terms in lending.
In view of this, special attention should be paid to manoeuvrability principle so as to assure that as the company grows in size it is able to obtain funds when needed and under acceptable terms.
This is why common stock represents major portion of the capital in smaller concerns. However, the management should also give special consideration to the factor of control because if the company’s common stock were publicly available, some large concern might hold a controlling interest.
In view of this, the management might insist on debt for further financing so as to maintain control or common stock should be sold in closed circle so that control of the firm does not pass in the hands of outsiders.
Large concerns have to employ different types of securities to procure desired amount of funds at reasonable cost because they find it very difficult to raise capital at reasonable cost if demand for funds is restricted to a single source. To ensure availability of large funds to financing future expansion programmes, larger concerns may insist on maneuverability principle.
Contrary to this, in medium-sized companies who are in a position to obtain the entire capital from a single source, leverage principle should be given greater consideration so as to minimize cost of capital.
(b) Form of Business Organisations:
Control principle should be given higher weightage in private limited companies where ownership is closely held in a few hands. This may not be so imminent in the case of public limited companies whose shareholders are large in number and so widely scattered that it becomes difficult for them to organize in order to seize control.
In such form of organization maneuverability looms large because a public limited company in view of its inherent characteristic finds it easier to acquire equity as well as debt capital.
In proprietorship or partnership form of organization manoeuvrability factor may not be helpful owing to limited access of proprietary or partnership concerns to capital market. Control is undoubtedly an important consideration in such organization because control is concentrated in a proprietor or a few partners.
(c) Stability of Earnings:
With greater stability in sales and earnings a company can insist of leverage principle and accordingly it can undertake the fixed obligation debt with low risk. But a company with irregular earnings will not choose to burden itself with fixed charges. Such company should, therefore, pay greater attention to risk principle and depend upon the sale of stock to raise capital.
(d) Asset Structure of Company:
A company, which has invested major portion of funds in long-lived fixed assets and demand of whose products is assured, should pay greater attention to leverage principle to take advantage of cheaper source. But risk principle will outweigh leverage principle in company whose assets are mostly receivables and inventory whose value is dependent on the continued profitability of the individual concern.
(e) Age of Company:
Younger companies find themselves in difficult situation to raise capital in the initial years because of greater uncertainty involved in them and also because they are not known to supplier of funds. It would, therefore, be worthwhile for the management to give more weightage to manoeuvrability factor so as to have as many alternative open as possible in future to meet their growth requirements.
In a sharper contrast to this, established companies with good earnings record are always in comfortable position to raise capital from whatever sources they like. Leverage principle should, therefore, be insisted upon in such concerns.
(f) Credit Standing:
A company with high credit standing has greater ability to adjust sources of funds upwards or downwards in response to major changes in need for funds than the one with poor credit standing. In the former case, the management should pay greater attention to manoeuvrability factor and should aim at improving credit standing of the latter by improving its liquidity and earnings potential.
(g) Attitude of Management:
Attitude of the persons who are at the helm of affairs of the company should also be analysed in depth while assigning weights to differed factors affecting the pattern of capitalisation. The management attitude towards control of the enterprise and risk in particular has to be minutely observed.
Where the management has strong desire for assured return and exclusive control, preference will have to be given to borrowing of funds.
Further, if the management’s chief aim is to stay in office, they would insist more on risk principle and would be loath in issuing bonds or preferred stock which might land the company in greater risk and endanger their position.
But if the members of the Board of Directors have been in office for a pretty long time, they would feel relatively assured and would prefer to insist on the leverage principle and assume more risk by resorting to further borrowing in their attempt to improve the company’s earnings.
Factors Affecting Capital Structure Decisions – 9 Most Important Determinants
A plethora of studies have been conducted to explore various factors affecting capital structure or determinants of capital structure in different countries, different sectors and overtime. Companies consider a number of factors while designing capital structure.
Some of the most important determinants or considerations are discussed below:
Determinant # 1. Tangibility of Assets:
Assets may be tangible (i.e. physical) or intangible (like goodwill, patent etc.). In deciding about firm’s capital structure, form of assets held by a company plays an important role. Tangible fixed assets serve as collateral securities for debt. In case of financial distress, the lenders can access these assets and sell them to realize funds lent by them.
Companies with higher tangible fixed assets can afford to have higher proportion of debt capital because they have less expected costs of financial distress. On the other hand, companies with higher intangible assets have lower debt capital due to higher costs of financial distress.
Determinant # 2. Profitability:
Profitability is measured in terms of ROI (Return on Investment) or Operating Profit Ratio. The higher the operating profit ratio the higher may be debt ratio because in that case the chances of not meeting interest cost will be low.
Determinant # 3. Cash Flows:
It is not sufficient to have operating profits to service debt capital. Interest and repayment of debt capital requires cash outflows. Hence another important factor to be considered while designing capital structure is cash flows or cash profits. If there is no scarcity of cash, then the company may afford to have higher debt ratio.
Determinant # 4. Growth Opportunities:
Firms with high market-to-book value ratios have high growth opportunities. These firms have a lot of investment opportunities. But there is also a higher cost of bankruptcy and financial distress if they start facing financial problems. These firms employ lower debt ratios to avoid the situation of financial distress. Hence, growth firms would prefer to take debt with lower maturity period to keep interest rates down and to retain the financial flexibility.
Determinant # 5. Debt and Non-Debt Tax Shields:
Due to interest deductibility, debt reduces the tax liability and increases the firm’s after tax cash flows. Firms also have non-debt tax shields available to them like depreciation, carry forward losses, etc. This implies that firms with larger non-debt tax shields would employ low debt as they may not have sufficient profit available to them.
Determinant # 6. Financial Flexibility and Financial Slack:
Financial flexibility means that a company is able to adapt its capital structure to the needs of changing conditions. The company should be able to raise funds whenever needed for profitable projects, without undue delay and higher cost. It should also redeem its debt whenever warranted by the future conditions. So, the financial plan of the company should be flexible enough to change the composition of the capital structure.
Financial slack, which in a way is reserve capacity of funds, includes unused debt capacity, excess liquid assets and access to various untapped sources of funds. If a company borrows to the full limit of its debt capacity, it will not be in a position to borrow additional funds for financing of any unforeseen and unpredictable demands. Therefore, company should maintain some financial slack and maintain financial flexibility.
Determinant # 7. Issue Costs and Floatation Costs:
These costs are incurred when the funds are raised externally either through debt or equity. Generally, cost of issue of debt is less than the issue cost of equity which encourages the companies to use debt more than equity. Retained earnings do not have any floatation costs and therefore many large firms prefer to use internal equity rather than raising funds through external debt or equity capital.
Determinant # 8. Management’s Attitude towards Control:
If the management of the company does not want to dilute its control over the company then new funds are generally raised through debt capital. This way they ensure that more equity shareholders are not added to the company and the existing shareholders exercise control over the company.
Determinant # 9. Capital Market Conditions:
Capital structure of a firm also depends upon the capital market conditions. External equity is generally issued only when investors’ confidence is high in equity market and cost of equity is low. If capital market condition is not good then the company has no option but to raise debt capital.
Factors Affecting Capital Structure Decisions – Optimal Capital Structure
Capital structure may be determined at the time of formation of the firm or at later stages. But determining optimal capital structure at the time of formation is very important and it should be designed very carefully. Management of any firm should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure.
Construction of capital structure, is difficult, since it involves a complex trade-off among several factors or considerations. Keeping in view the objective of wealth maximisations in mind capital structure has to be determined.
The following are the factors that affect optimal capital structure:
1. Tax Benefit of Debt:
Debt is the cheapest source of long-term finance, when compared with other source of equity, because the interest on debt finance is a tax-deductible expense. Hence, debt can be accepted as tax-sheltered source of finance, which helps in shareholders’ wealth maximisation.
2. Flexibility:
Flexibility is the most important and serious factor, which needs to be considered while determining capital structure. Flexibility is the firm’s ability to adopt its capital structure to the needs of the changing conditions. Changing conditions may need more funds for investments or no need of having funds that are already raised.
Whenever there is a need to have more funds to finance profitable investments, the firm should be able to raise funds at less cost and without delay. On the other hand, whenever there is no need to keep borrowed funds, the firm should be able to repay them. The above two conditions are fulfilled only when there is a flexible capital structure.
In other words, the financial plan of a firm should be able to change according to their operating strategy and needs. The flexibility of capital structure depends on the flexibility in fixed charges, covenants and debt capacity of the firm.
3. Control:
Equity shareholders have voting rights to elect the directors of the company. Raising funds by way of issue of new equity shares to the public may lead to a loss of control. If the management wants to hold control on the firms then it may require to raise funds through non-voting right instruments that is debt source of finance. But the firm needs to pay interest compulsorily on debt finance.
Debt finance is preferred only when the firm’s debt service capacity is good. Otherwise, the creditors may seize the assets of the firm to satisfy their claims (interest). In this situation the management would lose all control. It might be better to sacrifice a measure of control by some additional equity finance rather than run the risk loss of all control to creditors by employing too much debt.
Widely held companies can raise funds by way of issue of equity shares, since shares are widely scattered and majority of the shareholders are interested in the returns. At the same time if they are not satisfied with the firm, they will switch over to other firms where they expect higher returns.
4. Industry Leverage Ratios:
Industry standards provide a benchmark. Firms can use industry leverage ratio as standard for construction of capital structure. Because industry standard may be appropriate to the firm. But it does not mean that firms in the industry are having optimum capital structure. Put it simply, they may be using more leverage or less leverage, but it suggests that whether the firm is out of line or not, if it is, it should know the reasons why and be satisfied that there are good reasons for it.
5. Seasonal Variations:
Use of more or less financial leverage depends on the seasonality of the business. Low degree of financial leverage (less debt) is preferable when a firm’s business is seasonal in nature. In other words, more equity finance is preferable when a firm’s business is the nature of seasonal business. For example, businesses involved in producing and sale of umbrellas, fans, air coolers, require to use less debt capital in their capital structure.
Use of more debt may make a firm unable to pay interest obligations in the lean period, which would lead to financial distress. On the other hand, industries involved in business where there is no seasonality, like consumer non-durable products (food items, soaps, etc.,) or with items in habitual use (cigarette) or all those products, which have an inelastic demand and are not likely to be subjected to wide fluctuations in sales, can use more debt in their capital structure, since they are able to earn regular profit.
6. Degree of Competition:
Competition in the industry also determines the capital structure. When there is no or less competition (public utility corporations like gas, electricity, etc.,) firms can use less equity or more debt in their capital structure, since they can sell products at higher prices.
On the other hand, competitive firms like garment industry, home appliances industry have to use more equity in their capital structure, because of competition, they may not be able to sell more units and cannot earn more profits.
7. Industry Life Cycle:
Industry life cycle consists of infancy stage, growth stage, maturity stage and declining stage. When the industry is in infancy stage, a firm should use less debt capital or more equity capital in is capital structure, because the profit earning capacity is less due to less sales whereas when a firm is in growing stage (fast) and having more profits, it can go for more debt or less equity that helps to maximise shareholders’ wealth.
Therefore, the company has to decide whether to finance infancy stage with equity funds and later stages (except declining) with debt funds or vice versa.
8. Agency Cost:
Agency cost is the cost that arises when there is a conflict of interest among owners, debenture holders and management. Conflict may arise due to the transferring of wealth to debt holders in their favour. The agency problem is handled through monitoring and restrictive covenants, which involve costs that are called agency costs.
The financing strategy of a firm should seek to maximise the agency cost, by way of employing an external agent who maximises in low-cost monitoring. Management should use debt finance to the extent that it maximises the wealth of shareholders, not beyond that.
9. Company Characteristics:
These represent are size and credit standing among other companies (within or outside industry). Small firms’ ability to raise funds from outside is limited when compared to large firms. Small firms have to depend on owners’ funds for financing activities. In other words, investors perceive that investment in small firms is more risky than the large firms. On the other hand, large firms are forced to make use of different sources of funds, because no single source is sufficient to provide for their needs.
When it comes to the credit rating characteristic of a firm enjoying high credit rating it may get funds easily from the capital market, when compared to other firms, which are having low credit rating. Because investors and creditors prefer to invest and grant loans to high credit rating firms, since the risk is less.
10. Timing of Public Issue:
Timing of the public offer is also one of the important factors considered while planning capital structure. Public offering should be made at a time when the state of the economy as well as capital market is ideal to provide the funds. For example – 2003 to 2004 period Vijaya Bank, IOB, Union Bank, TCS, IOC, NTPC have come up with IPO is due to the ideal capital market and the economy.
Prices as well as yield on securities depend on the monetary policy pursued by the government. Scarcity of debt money and equity funds leads to high interest rates and low price earnings (P/E) ratios.
11. Requirements of Investors:
Before issuing an issue of a particular instrument to the public or investors’ to raise funds, there is a need to know the investors’ requirements. Investors may be institutional investors (LIC of India, GIC, UTI), as well as individual investors. Some investors are ready to take risk (bold investors), who prefer capital gains and control and hence, equity shares are suitable to them.
On the other hand, investors (cautious) who are interested in safety of the investment and stable returns, prefer to invest in debentures, since they satisfy their needs and preference shares are very much suitable to the investors who (less cautious) prefer stable returns and share in profits.
12. Period of Finance:
Period of finance also plays a crucial role in determination of capital structure. A firm can issue redeemable debentures or preference shares, when the finance is required for a limited period. For example – for 5 years, the firm can issue 5 years redeemable debentures or preference shares. But equity share capital is the best source when the firm needs finance for unlimited period.
13. Purpose of Finance:
Debt source of finance is suitable when a firm is planning to invest in productive purpose. For example – a firm is planning to raise funds for social responsibility (non-productive purpose), it can raise funds from equity source.
14. Legal Requirements:
There are some guidelines on the issue of shares and debentures issued by the government that are very important for construction of capital structure. For example – the controller of capital issues, now SEBI grants this consent for capital issue when, (a) debt- equity ratio does not exceed 2:1 (higher ratio may be allowed for capital intensive projects), (b) the ratio of preference capital to equity capital does not exceed 1:3 and (c) promoters hold at least 2.5 per cent of the equity capital.
Factors Affecting Capital Structure Decisions: Important Factors to be Kept in Mind (with Ratio)
The capital structure of a company is planned initially when the company is floated. The initial capital structure must be designed very carefully, since it will have long-term implications. However, the capital structure decision is a continuous one and has to be taken every time whenever a firm needs additional finances. There are a number of factors which affect the capital structure of a firm.
Some of the important factors which must be kept in mind while determining the capital structure are discussed below:
Factor # 1. Size of the Firm:
Usually small sized firms depend on owned capital and retained earnings for their long-term funds. This is because these firms face great difficulties in raising long-term loans. However, if they are able to raise some long-term loan, it will be available at a very high rate of interest and on inconvenient terms. A lot of restrictions are put by debt-holders, specifically by the financial institutions which curtail the freedom of the management to run the business. Hence, long-term loans are neither available nor preferred by small sized firms.
Also, it is quite difficult for small companies to raise share capital by issuing shares in the capital market. Reasons are – Firstly, the capital base of small companies is so small that they are not allowed to be registered on the stock exchange. Secondly, since the size of issue will be small, cost of issuing shares will be more in comparison to the large sized companies. Thirdly, there is a risk of loss of control by existing shareholders because the shares of small company are not widely scattered and the new shareholders can easily organise to get control of the company.
Hence, the small companies restrict their growth to the extent which can conveniently be financed from internal sources.
In contrast, large sized firms can raise long-term loans at comparatively cheaper rates and on easy terms and can also issue equity shares, preference shares and debentures to the public. Because of issue of larger number of shares, the cost of issue is also low in comparison to small sized firms. Hence, a large company can employ various sources of finance and has flexibility in designing its capital structure.
Factor # 2. Stability of Earnings:
The companies, which have regular and increasing sales and earnings, may resort to higher debt, i.e., high degree of leverage in their capital structure. This is because such companies will not face any difficulty in paying the interest and debts on time. On the other hand, the companies, which face frequent fluctuations in sales and earnings, should not employ higher debt because they run the risk of being unable to pay the interest and the principal on time which would cause financial distress.
Factor # 3. Degree of Competition:
If there is keen competition in an industry, the firms in that industry should use relatively a greater proportion of equity than debt. On the other hand, the industries which do not have high degree of competition will have a tendency of stable sales and therefore, the firm engaged in such type of industry can afford to use more debt.
Factor # 4. Stage of Life Cycle of the Firm:
If a firm is in its initial stages, the chances of its failure would be high. Hence it should put more emphasis on the use of equity capital. It should avoid the use of long-term loans which require fixed payment of interest. When the firm grows and reaches maturity it may resort to long-term debts.
Factor # 5. Interest Coverage Ratio:
This ratio measures the ratio of fixed interest payments in relation to the profitability of the business. It determines whether the company has the capacity to meet its fixed interest obligations or not. The higher the coverage ratio, the greater will be the capacity of the firm to meet its obligations of interest payment and hence more amount can be used as debt.
The ratio is calculated as under:
Factor # 6. Cash Flow Ability of the Firm:
Sometimes, the interest coverage ratio of a firm is quite high but it does not have sufficient cash to pay its fixed charges in time which include payment of interest, principal and preference dividends. This may be due to the reason that the firm’s income is blocked within the firm in the form of high inventory, debtors and sometimes purchase of fixed assets.
Hence, whenever a company thinks of raising additional debt, it must analyse its future cash flows to meet its fixed charges. The companies which expect larger and regular cash inflows in future can use larger amount of debt in their capital structure. The capacity of the company to generate cash flows to meet its fixed charges can be examined by using the ratio of net cash inflows to fixed charges. The greater the ratio, the greater will be the capacity of company to use the debt.
Factor # 7. Cost of Capital:
The cost of different sources of capital has a vital effect on the capital structure of a firm. Different sources of capital must be combined in such a proportion that the cost of capital is minimum and the degree of risk is within manageable limits. Debt is a cheaper source of finance in comparison to equity capital due to two reasons – (i) The rate of interest on debt is lower than the rate of dividend expected by equity shareholders, and (ii) Interest on debt is deductible from profits while computing tax whereas the dividend is paid out of post-tax profits.
Hence, debt is preferable to equity capital from the cost point of view. The cost of preference share capital lies between the cost of debt and the cost of equity share capital.
Factor # 8. Rate of Corporate Tax:
Rate of corporate tax is likely to have a significant bearing on the capital structure of a company. Interest on debt is tax deductible whereas dividend is paid out of post-tax profits. Hence, higher the rate of tax, greater will be the advantage of using debt as compared to preference and equity capital. More use of debt in the capital structure of a company helps to increase the profits available to equity shareholders.
Factor # 9. Retaining Control:
The existing management of the company does not want to lose their control over the company. Equity shareholders have a right to vote and appoint directors in the meeting of the company and hence, in case the company raises funds through issue of new equity shares, there is risk of dilution of control. A group of shareholders can purchase all or most of the new shares and control the company. To avoid the risk of loss of control, the companies prefer to issue preference shares or debentures because they do not have voting rights and elect the directors.
However, it should be remembered that if the company borrows more than its interest and debt repaying capacity, the lenders may seize the assets of the company to satisfy their claims. In such a case the management would lose all control. Hence, it might be better to sacrifice some control by issuing some additional equity shares rather than run the risk of losing all control by raising too much debt.
Factor # 10. Flexibility:
Capital structure of a firm should be flexible, i.e., the firm should be capable of changing its sources of funds in either direction i.e., increase or decrease, in response to changes in the needs for funds. It should be capable of raising additional funds without undue delay and cost, whenever needed and it should also be able to decrease the funds by redeeming the preference capital and debentures when the funds are not needed.
It should also be able to substitute one source of finance for another to achieve economy. For instance, if the funds are available at 14% rate of interest presently and the company has outstanding debt at 18% rate of interest, it can save interest cost if it can replace the old debt by the new debt. Preference shares and debentures offer the highest flexibility in the capital structure of a firm because they can be redeemed at the discretion of the firm.
Factor # 11. Capital Market Conditions:
Capital market conditions go on changing from time to time. Sometimes there may be depression while at other times there may be boom conditions in the capital market. If the share market is depressed, the company should not issue equity shares, but issue debentures because the investors would prefer safety than profitability. On the contrary, in the boom period in the share market, the investors want to earn speculative incomes, and hence at such times, it will be appropriate to raise funds by issue of equity shares even at high premium.
Factor # 12. Credit Standing of the Firm:
Firms which enjoy high credit standing from the viewpoint of investors and lenders in the capital market are in an advantageous position to raise finance on easy terms and from the sources of their choice. But in case the firm’s credit standing is poor, the firm will not be able to get finance from the source of its choice.
Factor # 13. Trading on Equity:
The use of fixed cost sources of finance, such as debts and preference share capital is termed as trading on equity or financial leverage. In case the assets acquired from the debt funds yield a return greater than the cost of debts, the profits available to equity shareholders or the earning per share (EPS) will increase.
EPS will also increase by the use of preference share capital but it will increase more in case of use of debt because the interest paid on debt is deductible from profits while calculating the tax. Hence, the alternative methods of financing must be analysed by the management to examine their effect on EPS.
Factor # 14. Legal Requirements:
The Government issues guidelines for the issue of shares and debentures from time to time. While designing its capital structure, the firm should consider these guidelines and also the relevant provisions of different laws framed by the Government. In addition, it should also take into consideration the rules framed by Securities and Exchange Board of India (SEBI), the stock exchanges and the norms set by financial institutions from time to time.
Factor # 15. Flotation Costs:
Flotation costs are the costs incurred at the time of raising finance. These include underwriting commission, brokerage, cost of printing and publicity etc. Normally, the flotation cost of raising debt is lower than that of issuing the shares. This may encourage a company to raise debt than issue shares. But flotation costs are not a significant consideration to decide about the source of finance because flotation costs as a percentage of funds raised will decline with the increase in size of the share issue.
Factor # 16. Leverage Ratios for other Firms in the Industry:
While making capital structure decisions, the debt equity ratio of the firm should be compared with the debt equity ratios of other firms belonging to the same industry, having a similar business risk. If the debt equity ratio of a particular firm is different than the industry standard, it acts as a warning to the management and the management should ascertain the reasons for the deviation.
Factor # 17. Nature of Investors:
Investors may be classified in different categories on the basis of their outlook towards risk and return. Some investors are of enterprising nature. They prefer to take higher risk to earn higher return and hence equity shares should be issued to meet their requirements. On the other hand, some investors are of conservative nature. They do not want to take higher risk and are satisfied with lower return and hence debentures of preference shares should be issued to meet their requirements.
Factor # 18. Consultation with Investment Bankers and Lenders:
While determining the proportion of various securities in a firm’s capital structure, it is very useful to seek the opinion of institutional investors, investment bankers and lenders. They possess information about the capital structure of large number of companies and know as to the demand of various securities in the capital market.
Hence, their opinion can be very useful while taking a decision about the capital structure. Similarly, prospective lenders and investors should also be consulted because it is they who will ultimately provide finances to the company. The type of securities which they will prefer to invest is very important information for the company.
Factor # 19. Attitude of Management:
Lastly, the attitude of the management towards all the factors discussed above will finally determine the capital structure of the firm. Management of various firms differs in skills, judgement and experience. Some managements are enterprising and they are prepared to take higher risk to reduce the cost of capital. Such managements do not hesitate to use more of debt in their capital structure. On the other hand, some managements are conservative and they do not want to take high risk. They prefer the use of more amount of equity capital in comparison to debt.
The above factors must be considered while designing an optimum capital structure of a company. However, these factors do not yield an optimum capital structure by themselves because some of these factors are conflicting in nature. For example, the debt is a cheaper source of finance and hence a company should use more amount of debt to reduce the cost of capital but the enlarged use of debt increases the risk and hence the company cannot use more amount of debt. Moreover, it should be remembered that –
‘Financial theory has not developed to the point where data related to these considerations are fed at one end of a computer and an ideal financial structure pops out of the other. Consequently, human judgement must be used to resolve the many conflicting forces in laying plans for the types of funds to besought.’ —R. W. Johnson