Capital Structure of a Firm: Meaning, Essentials and Factors

After reading this article you will learn about:- 1. Meaning and Concept of Capital Structure 2. Balanced or Optimum Capital Structure 3. Essentials Characteristics 4. Objectives 5. Factors.

Meaning and Concept of Capital Structure:

For any business (investment) project, it is essential to estimate the amount of capital likely to be required for the business. After having determined the finance required for a project to be undertaken, the question arises what shall be the sources of finance, i.e., what are the securities to be issued and what shall be the proportion of various securities.

The main types of securities are:

1. Ordinary shares (or Equity shares),

2. Preference shares, and 

3. Debentures.

Capital structure refers to the mix or proportion of different sources of financing to the total capitalisation. In other words, capital structure refers to the proportion of Equity capital, Preference capital, Reserves, Debentures and other long-term debts to the total capitalization. So, capital structure signifies the kind and proportion of different securities for raising long-term finance. Capital structure involves the decision about the form of capitalization i.e. the types of securities to be issued and the relative proportion of each type. Capital structure refers to the makeup of the capitalization.

It decides the proportion of funds to be raised by:

(i) Issue of ownership capital (i.e., ordinary share capital and preference share capital) and

(ii) The amount to be raised by borrowings (i.e., debentures, bonds, public deposits etc.) taking into account the cost of capital (i.e., dividend or interest) and its impact on income and stability of the company.

A company should maintain a fair balance in two types of securities i.e. ordinary shares (variable cost bearing securities) and other securities (bearing fixed cost).

Capital structure may consist of:

(i) Only equity shares (also known as ordinary shares),

(ii) Equity shares and preference shares,

(iii) Equity shares, preference shares and debentures, and

(iv) Equity shares and debentures.

Capital structure differs from financial structure and Assets structure. While financial structure refers to total liabilities, Assets structure refers to total assets, capital structure refers to total assets less current liabilities. Capital structure theories explain the theoretical relationship between cost of capital and the value of a firm.

The important theories are:

1. Net income (NI) approach,

2. Net operating income (NOI) approach,

3. Modigliani and Miller (MM) approach, and

4. Traditional approach.

Capital structure planning refers to the designing of an appropriate capital structure in the context of the facts and circumstances of each firm. The optimum capital structure may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm.

Balanced or Optimum Capital Structure:

Capital structure refers to the composition of various long term sources of funds such as debentures, ordinary shares, preference shares, reserve and surplus etc. An optimum or balanced capital structure means an ideal combination of borrowed and owned capital that may attain the marginal goal i.e., maximization of market value per share or minimization of cost of capital. The market value will be maximized or the cost of capital will be minimized when the real cost of each source of funds is the same.

A sound/ideal optimum structure is one which:

(1) Maximises the worth or value of the concern.

(2) Minimizes the cost of funds.

(3) Maximizes the benefit to the shareholders, by giving best earning per share and maximum market price of the shares in the long run.

(4) Is fair to employees, creditors and others.

Essentials Characteristics of an Optimum Capital Structure:

The optimum capital structure can be properly defined as that security mix (i.e. of different types of securities such as ordinary shares, preference shares, debentures etc.) which minimises the firm’s cost of capital and maximises firm’s value.

Following are the essentials or characteristics of an optimum capital structure.

(1) Simplicity:

The capital structure should be simple so that even less educated businessmen are able to understand it. For simplicity, at least in the beginning, the concern should resort to minimum types of securities as a source of finance. The investors will also respond quickly.

(2) Flexibility:

The capital structure should be flexible so that whenever the circumstances so warrant, it is capable of being altered. For example, a sound capital structure should be such that the capital can be increased or reduced when the concern wants to expand or limit its activities respectively. Usually the increase in capital is not a problem but reduction of capital is very difficult. Equity capital is considered to be something sacred which cannot be reduced except in accordance with the provisions of Companies Act, 1956. Flexibility can be introduced into capital structure by opting for redeemable preference shares or redeemable debentures as one of the securities to be issued for raising finance.

(3) Profitability:

An optimum capital structure is one that is most profitable to the company. The cost of financing should be the minimum and the earnings per share should be maximum.

(4) Solvency:

In an optimum capital structure, debts should only be a reasonable proportion of the total capital employed in the business because extensively used and huge debts always threaten the solvency of the company.

(5) Control:

Sound capital structure should provide maximum control of the equity shareholders on the company’s affairs. When owners want to have control over the business, debt is preferred to equity.

(6) Conservation:

The capital structure should be conservative in the sense that the debts shall not be raised beyond a certain limit so that the company is in a position to repay the principal sum together with the interest due thereon in time.

(7) The capital structure selected should be most economical.

(8) Future contingencies should be anticipated and a provision be made in the capital structure to meet them.

(9) Sufficient funds should be there with the company for different operations. Both surplus or scarcity of capital have adverse effect on the profitability of the concern.

(10) Securities proposed to be issued should offer some attractions to the investors either in relation to income, control or convertibility.

(11) Both types of securities i.e., ownership and creditor-ship, should be issued to secure a balanced leverage.

Normally, debentures are issued when rate of interest is low and shares, when rate of capitalisation is higher.

Objectives of Optimum Capital Structure:

(A) Economic Objectives:

(1) Minimisation of Costs:

Funds should be raised at the lowest possible cost in terms of interest, dividend and the relationship of earnings to the prices of shares.

(2) Minimisation of Risks:

Business risks, management risks, tax risks, trade cycle risks, purchase risks, interest rate risks, etc., should be minimized by making suitable adjustments.

(3) Maximisation of Return:

Equity shareholders should get maximum return. It may be achieved by minimizing the cost of issue and the cost of financing.

(4) Preservation of Control:

The control of equity shareholders on company’s affairs should be preserved by proper balance between voting right capital (equity capital) and limited voting (or non-voting) right capital (preference shares and debentures).

(5) Proper Liquidity:

Liquidity is necessary for the solvency of the company, therefore, a proper balance between fixed assets and the liquid assets should be maintained.

(6) Full Utilisation:

Full utilisation of available capital should be made at minimum cost. For this, there should be a proper coordination between the quantum of capital and the financial requirements of the business.

(B) Other Objectives:

(1) Simplicity:

The capital structure should be simple. In the beginning a company should raise only the ownership capital i.e., equity share capital that will enhance the credit of the company.

(2) Flexibility:

The capital structure (design) should be flexible so that it can be altered as per the requirements or need of the company.

Factors Determining Capital Structure:

Every time when the company wants to expand or grow, more finances are required and the problem is there in respect to the suitable sources of finance.

Thus, a decision as regards capital structure is taken, considering the following factors:

(1) Trading on Equity:

When the debt and preference share capital are used as main sources of finance, the situation is termed as trading on equity. Under such a case, an enterprise earns a higher rate of return on capital employed than the rate of interest payable on borrowed funds. The earning per share increases without a corresponding increase in the equity shareholder’s investment.

(2) Control of Business:

Normally, the promoters want to retain with them the control of the affairs of the business company. So, majority of equity share capital is held by the promoters or their near relatives and a large proportion of fund is raised by the issue of debentures and preference shares because debenture holders and preference shareholders usually do not have any voting right as enjoyed by the equity shareholders.

(3) Nature of Business:

While designing capital structure, nature of business must be taken into account. Public utility concerns may enjoy advantages of fixed interest securities like bonds and debentures 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 capital.

(4) Size of Business:

Small companies have to depend on owned capital whereas large companies do not find much difficulty in raising long-term funds/loans.

(5) Period of Finance:

If funds are required for ten years or so, debentures are preferred to shares, whereas if the requirement of funds is permanent, equity shares are more appropriate to be issued. If the funds are required for five years or so, they may be arranged through borrowings because these can easily be repaid as soon as company’s financial position improves.

(6) Cost of Capital:

The cost of a source of finance should be minimum. The cost of capita! is found on the basis of the return expected by the supplier of the particular source of finance. Expected return depends on the extent of risk which is assumed by various Suppliers of finances. Usually debt is cheaper than equity because debt holders assume less risk than shareholders. Preference share capital is also cheaper than equity capital, but debt is still cheaper as it involves tax advantage in respect of deductibility of interest.

(7) Purpose of Financing:

If funds are to be raised for production/manufacturing purposes, debt may be a proper source of finance. For non-productive purposes (e.g. constructing houses for employees) which will add nothing to the earning capacity of the company, funds may be raised by issue of shares or still better out of retained earnings, but in no case, out of borrowed funds.

(8) Choice of Investors:

If the investors (i.e., the public) are not ready to buy preference shares or debentures even when the company feels that these are the most appropriate source of finance for them, these cannot be issued. Only that issue would be successful which has ready marketability.

(9) Need of Investors:

An ideal capital structure is that which suits to the needs of different types of investors. For example, some investors who prefer security of investment and stability of income usually go in for debentures. Preference shares are liked by those who want a higher and stable income with enough safety of investment. Equity shares will be taken 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.

(10) Future Cash Inflows:

The greater and more stable the expected future cash flows of the firm, the greater is the debt capacity of the company.

(11) Stability of Ssales:

The companies which have stable and increasing sales may resort to more debt financing without any difficulty.

(12) Legal Restrictions:

Hands of the management are tied by the legal restrictions as regards the issue of different types of securities For example, there is 4: 1 ratio between debt and equity and 3: 1 between equity and preferred stock.

(13) Cost of Floatation:

Cost of floatation should also be taken into consideration while raising funds. The cost of floating a debt is normally less than the cost of floating an equity issue.

(14) Flexibility/Elasticity of Capital Structure:

Capital structure should be flexible or elastic enough so as to provide for expansion for future development or to make it feasible to reduce the capital when it is not needed.

(15) Regular and Fixed Income:

The stability of capital structure of a company very much depends upon the possibility of regular and fixed income. If company wants sufficient regular income in future, debentures should be issued. Preference shares may be issued if the company wants that its average income for a few years may be equal to or in excess of the amount of dividend to be paid on such preference shares. If the company does not expect any regular income in future, it may issue equity shares.