Capital Structure - Meaning

and Factors Determining

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 decisions-

a. 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 two-
a. Highly geared companies- Those
companies whose proportion of equity
capitalization is small.
b. Low geared companies- Those companies
whose equity capital dominates total
Financial Management capitalization.

  
For instance - There are two companies A and B.
 Financial Management - Introduction
Total capitalization amounts to be Rs. 20 lakh in
 Financial Planning each case. The ratio of equity capital to total
 Capital Structure capitalization in company A is Rs. 5 lakh, while in
 Capitalization in Finance 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
company’s 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 company’s 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 company’s 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 company’s capital structure generally consists of
debentures and loans. While in period of boons and
inflation, the company’s 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