Capital Structure

Meaning of Capital Structure Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance.
The capital structure involves two decisionsa. Type of securities to be issued are equity shares, preference shares and long term borrowings( Debentures). b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into twoi. Highly geared companies- Those companies whose proportion of equity capitalization is small. ii. Low geared companies- Those companies whose equity capital dominates total capitalization. For instance - There are two companies A and B. Total capitalization amounts to be Rs. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Rs. 5 lakh, while in company B, ratio of equity capital is Rs. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company. Factors Determining Capital Structure 1. Trading on Equity- The word equity denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of companys earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high. 2. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the companys management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. 3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. 5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. 6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. 7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. 8. Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases. 9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.
Factors-Affecting-Capital-Structure-Decisions
1. Business Risk
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Business risk is the basic risk of a firm's operations without factoring in debt. Greater business risk should be countered by a lower debt ratio in a firm's capital structure. For example, a fine art gallery has more risk than a utility company. A fine art business is subject to changing trends and economic conditions, which make the potential of losing higher. Therefore, it is advisable for businesses in the fine art industry to have a lower debt ratio. The utility company, on the other hand, has a more stable revenue stream.
Tax Exposure
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Applicable tax laws and regulations may also play an important role in capital structure decisions. Since debt payments are tax deductible, if a company's tax
rate is high, it may make sense to use debt as a means of financing. The tax deductibility of debt payments will protect some income from taxation.
Financial Flexibility
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The lower a firm's debt ratio, the more flexibility the company has during difficult economic periods. Financial flexibility is a company's ability to raise capital during slow-growth periods. The airline industry is known to have poor financial flexibility in a stagnant economy.
Management Style
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Preference in management style may affect what type of capital structure business owners choose. Conservative managers are less likely to use debt to raise funds. On the other hand, aggressive management styles attempt to create rapid growth, which may require larger amounts of debt.
Growth Stage
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A business firm's capital structure may also depend upon the enterprise's current growth stage. Companies in the initial growth stages may tend to take on more debt in order to facilitate growth. However, many times firms may grow too rapidly, which causes their growth to be unstable. Firms that are more stable usually require less debt, due to more stable revenue streams.
Market Conditions
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Market conditions are a significant factor in making capital structure decisions. In a stagnant market, investors may be less likely to invest capital; therefore, interest rates may be significantly higher. Therefore, companies may tend to avoid a high debt ratio during a struggling market.

Capital Structure

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Meaning of Capital Structure Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance.

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