15

Meaning of Capital Structure

Capital Structure

The tem Capital Structure refers to the proportion between the various
ol
long-term sources of finance in the total capital of the firm. The major sources
ong-term finance include Proprietor's Funds and Borrowed Funds' Proprietos
(i.e., retained
Funds include equity capital, preference capital, reserves and surpluse
financial
Funds include long-term debts such as loans from
Borrowedetc.
earnings) anddebentures
institutions, In the capital structure decisions, it is determined as to

the total
what should be the proportion of each of the above sources of finance in
of
capital of the firm. In other words, how much finance is to be raised from each these
to
sources. 1These sources differ from each other in terms of risk and their cost
tne
whereas others are more costly
Some sources are less costly but more risky
enterprise.
but less risky, To ilustrate, debentures are least costly source of finance (because rate
is
interest paid on debentures
of interest is usually lower than the rate of dividend and it
deducted from profits while calculating the taxes) but these are most risky (because
involves a burden to pay the interest irrespective of the profits earned by the company
and the debentureholders can move to the court to recover the interest and he principa

share capital costlier source of finance

is the most
amount). On the other hand, equity
interest on debentures
by equity areholders is greater than the
(as return expected is no fixed
these are least risky (as there
and the dividend on preference shares) but Preference share capital
commitment to pay dividend and the returm of equity capital).
in terms of risk and cost.
lies between debentures and equity capital to
financial manager makes an attempt
While choosing the source of finance a
For this purpose he has to
answer

ensure risk as well as cost of capital is minimum.

that
the followving questions:
How much amount through issue of equity?
should be raised
()
issue of preference share capital?
(i) How much amount should be raised through
debentures and other long-term
(ii) How much amount should be raised through
debts?
the financial
finance raised from various sources,
While deciding the proportion of
finance and selects the most
the and cons of various sources of
manager weighs pros and external
sources. The selection
also depends on various internal
advantageous different
structure can be different among
factors and hence the pattern of capital business.
diffèrent companies in the same
businesses and also among the
Structure
Importance of Capital the financial
taken by
is of the strategic decisions
Capital structure decision
one
decide the mix up of various
Considerable attention is required to
management. cost of
structure decision reduces the
sources of finance. A judicious
and right capital
while wTong decision
can adversely affect
and increases the value of a firm
a
capital
 CAPITAL STRUCTURE

15.2 differ in terms of

various sources of finance
discussed earlier, structure,
the value of the fim. As need of designing
an appropriate capital
reasons
cost. Hence, there is utmost
the following
risk and structure decisions are of great significance
due to

Capital by the fim.

structure determines the risk assumed
(i) Capital of the fim.
structure determines the cost of capital
(ii) Capital
It affects the flexibility and liquidity of the fim.
wmln
(iin)
(iv) It affects the control of owners on the firm.
Optimum Capital Structure
of the optimum
firm is calledwhen
structure which
maximises the value cost
The capital words, the capital structure is said to be optimunm
order to
capital structure. In other total he firm is maximum.Hence,in
and value of financial manager
ofcapital is minimumof maximisation.of shareholder's wealth, the
achieve the objective structure for the firm.
should determine an optimum capital Capital Structure
o r Sound
Features or Characteristics or Qualities of Optimum
characteristics
structure should have the following
Anoptimum capital should be simple, so
far as possibte.
structure
Simplicity: The capital the minimum type
.

to equity and preference capital,

means that in addition and preference shares
Simplicity be issued. Initially only equity
of long-term securities should later stage.
should be issued at a
should be issued and debt instruments so that it may
structure should be
adequately flexible
Flexibility: The capital to change its capital
be possible for a company
be altered when needed. It should Use of
if warranted by changed circumstances.
structure with minimum cost and delay raised when needed
more flexible because it can be
debt makes the capital structure

and redeemed when not required.

minimum risk. The use of
structure should ensure
) Minimum Risk: Capital because it involves a fixed
excessive debt threatens the solvency of the firm the
Debt should be used to
commitment to pay the interest irrespective of the profits.
should be avoided.
the use of debt
extent significant risk. Beyond this,
it does not add
interest on debts or
Cost of capital means
4) Minimum Cost of Capital: finance in comparison to equity capital
dividend on shares. Debt is a cheaper source of
shareholders and
return expected by equity
because rate of interest is lower than the
reduces the cost of debt. The preference
share
the tax deductibility of interest further
capital is also cheaper than equity capital, but not as cheap as debt. Thus, optimum
include sufficient amount of debt since it is the cheapest source
capital structure should
of finance.
firm to pay interest as
of the
(5)Sufficient Liquidity: Liquidity means the ability
well as principal in time. A firm is considered liquid pay the interest and
if it is able to
conditions. Hence, while determining the
principal under reasonably predicted adverse
a firm's liquidity
optimum amount of debt it should be carefully analysed as to how
will be maintained under recession conditions.
(6) Maximum Profitability : Capital structure of the company must provide
maximum return to equity shareholders. If there is a probability of earning higher
CAPITAL STRUCTURE

15.3
turn
oncompany's
company'S assets
ass in
comparison to the cost of debt, large amount o
a
d
used by
by the
the firm to maximise its
can be
employing debt capital, profitability, otherwise the fim should refrain
from
(7)Retaining
1 Control: Capital
structure should help the
retaining the conro over ne company. For this purpose debt present should management
be prelerred in
in

rison to
issue ot equity capital
while raising further funds. Debt holders
ssess voting rignts in company's meetings and hence cannot elect the directorsdo
posse otnot
the
company hereas equity shareholders possess voting rights.
(8 Avoidance of Unnecessary Restrictions: Capital structure
should
necessary restrictions on the firm. For instance, term oans from financial avoid un
should be avoided because these institutions impose a number of restrictionsinstitutions
on further
borrowing of the company.

Legal Requirements: Capital structure should fulfil all

requirements. Securities and Exchange Board of India (SEBI) issues certain the legal
guidelines
from time to time. These should be followed while
designing a capital structure
Factors Affecting or Determining Capital Structure
Thecapitalstructure of a company is planned initially when the company-is
floated. The initial capitalstructure 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 fim. Some of the important
factors which must be kept in mind while determining the capital structure are

discussedbelow: and
(1) Size of the Firm : Usually small sized firms depend on owned capital
retained cárnings for their long-term funds. This is because these firms face great,

difficulties in loans. However, if they are able to raise some

raising long-term
and on inconvenient
long-term loan, it will be available at a very high rate of interest
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,
small sized firms.
long-term loans are neither available nor preferred by
to raise share capital by issuing
Also, it is quite difficult for small companies base of small companies
shares in the capital market. Reasons arePirstly, the capital
be registered on the stock exchange,Secondly
is so small that they are not allowed' to
of issuing shares will be more in cômparison
since the size of issue will be small, cost
is a risk of loss of control by existing
to the large sized companies.|Thirdby, there scattered and the
are not widely
shareholders because the shares
of small company
to get control of the company.
Hence, the small
can easily organise
new shareholders be financed from
to the extent which can conveniently
companies restrict their growth
internal sources.
at comparatively cheaper
In contrast, large sized firms can
raise long-term loans and
can also issue equity
shares, preference shares
terms and of issue
rates and on easy number of shares, the cost
Because of issue of larger
debentures to the public. small sized firms. Hence,
a large company
can employ

to
is also low in comparison flexibility in designing
its capital structure.

various sources of finance and has

 CAPITAL STRUCTURE
15.4 increasing
and
regular
which have
of Earnings: The companies, in their
2 Stability resort to-higher debt, ie.,
high degree ot leveragein
sales and earnings
may
will not face any
difficulty paying
capital This
structure. is because such companies w h i c h tace frequent
the other hand, the companies,
time. On
the interest and debts
on
debt because they run the
should not employ higher
fluctuations in sales and earnings time which would cause
the interest and the principal on
of being unable to pay
risk
financial distress.
in an industry, the firms
Competition: If there is keen competition
Degree of than.debt. On the
(3) proportion of equity
in thatindustry should use relatively a greater of competition will have a
industries which do not have high degree
other hand, the such type of industry can
the firm engaged in
tendency of stable sales and therefore,
afford to use more debt.
the chances
firm is in its initial stages,
of Life Cycle of the Firm: Ifa
4) Stage Hence it should put more emphasis
on the use of equity
of its failure would be high. fixed payment of
loans which require
It should avoid the use of long-term
capital. it may resort to long-term debts.
When the firm grows and reaches maturity
interest. ratio interest
of fixed
ratio measures the
) Interest Coverage Ratio: This It determines whether the
in relation to the profitability of the business.
payments or not. The higher the
capacity its fixed interest obligations
to meet
company has the
the firm to meet its obligations of
ratio, the greater will be the capacity of ratio is calculated
coverage used as debt. The
interest payment and hence more amount can be
as under:

Interest Coverage Ratio :

Profit before Interest and Income Tax
Fixed Interest Charges
interest coverage ratio of a
(6) Cash Flow of the Firm: Sometimes, the
Ability
cash to pay its fixed charges in time
firm is quite high but it does not have sufficient
which include payment of interest, principal
and preference dividends. This may be
within the fim in the form of high
due to the reason that the firm's income is blocked
assets. Hence, whenever a
inventory, debtors and sometimes purchase of fixed
company thinks of raising additional debt,
it must analyse its future cash flows to meet
cash inflows in future
its fixed charges. The companies which expect larger and regular
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 néf
the capacity of
cash inflows to fixed charges. The greater the ratio, the greater will be
company to use the debt.

The of capital has a vital effect on

of different
Cost of Capital: cost sources
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 0The rateofinterest on dèbt is lower than the rate ofdividend
expected by equity shareholders, and () 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.
 15.5
CAPITAL STRUCTURE
of Corporate Tax Rate of corporate tax is likely to have a significant
(8) Rate :

on the capital structure of a company. As stated

earlier, interest on debt is taX
Dearing
deductible whereas dividend is paid out of post tax profits. Hence, higher the rate of
and equity
be the advantage of using debt as compared to preference
dx,greater will increase the
pital. More use of debt in the capital structure of a company helps
to
table
available to equity shareholders. It is illustrated in the following
profits
Alternativel Alternative II
119% I1%
Debenture Preferenee
Sharè Capital

Project Outlay n r 10,00,000| 10,00.000

Eamings Before Interest &Tax
(Suppose 25% on Project Outlay) 2,50,000 2.50,000
Less: Interest on Debentures @11% 1,10,000
Earnings Before Tax 1,40,000 2,50,000
Less Taxes (Suppose @45%) 63,000 1.12,500
Eamings After Tax 77,000 1.37500
Less Preference Dividend11. 1,10,000
77,000 27.500
Eamings available to Equity Shareholders
available to equity
Table shows that by using 11% Debentures, the eaming
11% Preference Share Capital, this earning
shareholders is 77,000 whereas by using to equity shareholders due to
IS T27,500. Hence, additional income available
only
income tax is F49,500 (i.e., F77,000 F27,500).
want
(9) Retaining Control: The existing management of the company does vote
not
and
shareholders have a right to
to lose their control over the company. Equity
raises
and hence, in case the company
appoint directors in thé meeting of the company
there is risk of dilution ofcontrol. A group
funds through issue of new equity shares,
of the new shares and control the company.
of shareholders can purchase all or most
to issue preference shares or
To avoid the risk of loss of control, the companies prefer
and elect the directors.
debentures because they do not have voting rights
more than its
it should be remembered that if the company borrows
However, to
lenders may seize the assets of the company
interest and debt repaying capacity, the
lose all control. Hence, it
their claims. In such a case the management would
satisfy some additional equity shares
be better to sacrifice some
control by issuing
might much debt.
rather than run the risk of losing
all control by raising too
be flexible, ie., the firm should
(I) Flexibility: Capital
structure
ofa firm should
direction i.e., increase or decrease,
of funds in either
capable of changing its
sources
be additional
funds. It should be capable of raising
in response changes in the needs for
to
also be able to
and cost, whenever needed and it should
funds without undue delay
the preference capital and debentures when the funds
decrease the funds by redeeming for another to
substitute one source of finance
needed. It should also be able to
are not 14% rate of intereest
if the funds are available at
achieve economy. For instance,
 15.6 -CAPITAL STRUCTURE
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.

1 ) 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 preter 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.
12) Credit Standing ofthe 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 easy terms and from the sources of their choice. But in case
on
the firm's credit standing is poor, the firm will not be able to get finance from the
source of its choice.
(13) Trading on Equity : The use of fixed cost sources of finance, such as debts
and preference share capital is termed as trading onequity 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 thetax. Hence, the alternative methods of financing must be
analysed by the management to examine their effect on EPS. To illustrate :
 (14) Legal Requirements: The Government issues guidelines for the of
issue
Shares and debentures from time to time. While designing its capital structure, the firm
should consider these guidelines and also the relevant provisions of ditferent laws
ramed 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.
) Flotatjon Costs: Flotation costs are the costs incurred at the time of raising
inance. These include underwriting commission, brokerage,-cost-of-printing_and
publicity_etc. Normally, the flotation cost of raising debt is lower than that of issuing
ne shares. This may eFcourage a company to raise debt than issue shares. But flotation
because
costs are not a significant consideration to decide about the source of finance
in size of
T1otation costs as a percentage of funds raised will decline with the increase
the share issue.

J6) Leverage Ratios for other Firms in the Industry : While making capital
with the debt
structure decisions, the debt equity ratio of the firm should be compared
cquity 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,
should ascertain the
it acts as a warning to the management and the management
reasons for the deviation.

Nature of Investors: Investors may be classified in different categories

on
(17)
investors are of enterprising
the basis of their outlook towards risk and return. Some
return and hence equity shares
nature. They prefer to take higher risk to earn higher
some investors are of
should be issued to meet their requirements. On the other hand,
conservative nature: They do not want to take higher
risk and are satisfied with lower
shares should be issued to meet their
return and hence debentures of preference

requirements.
Bankers and Lenders : While determining
(18) Consultation with Investment useful to seek
a firm's capital structure, it is very
the proportion of various securities in
investment bankers and lenders. They possess
the opinion of institutional investors,
number of companies and know as to
information about the capital structure of large
can be very
in the capital market. Hence, their opinion
the demand of various securities
about the capital structure. Similarly, prospective
useful while taking a decision who will ultimately
consulted because they
it is
lenders and investors should also be
securities which they will prefer to invest
finances to the company. The type of
provide
information for the company.
is very important