Factors Affecting Capital Structure

Factors affecting capital structure
Factor # 1. Financial Leverage:
 Factor # 1. Financial Leverage:

 The use of long-term fixed interest bearing debt and preference share
capital along with equity share capital is called financial leverage or
trading on equity. The use of long-term debt increases magnifies the
earnings per share if the firm yields a return higher than the cost of debt.
 The earnings per share also increase with the use of preference share
capital but due to the fact that interest is allowed to be deducted while
computing tax, the leverage impact of debt is much more.
 However, leverage can operate adversely also if the rate of interest on
long-term loans is more than the expected rate of earnings of the firm.
Therefore, it needs caution to plan the capital structure of a firm.
Factor # 2. Growth and Stability of Sales:
 The capital structure of a firm is highly influenced by the growth

and stability of its sales. If the sales of a firm are expected to remain
fairly stable, it can raise a higher level of debt. Stability of sales
ensures that the firm will not face any difficulty in meeting its fixed
commitments of interest payment and repayments of debt.
 Similarly, the rate of growth in sales also affects the capital structure
decision. Usually greater the rate of growth of sales, greater can be
the use of debt in the financing of firm. On the other hand, if the
sales of a firm are highly fluctuating or declining, it should not
employ, as far as possible, debt financing in its capital structure.
Factor # 3. Cost of Capital:
 Every rupee invested in a firm has a cost. Cost of capital refers to the
minimum return expected by its suppliers. The capital structure should
provide for the minimum cost of capital. The main sources of finance for a
firm are equity, preference share capital and debt capital.
 The return expected by the suppliers of capital depends upon the risk they
have to undertake.
 Usually, debt is a cheaper source of finance compared to preference and
equity capital.
Factor # 4. Risk: Business And Financial Risk
 Business risk refers to the variability of earnings before interest and taxes.
Business risk can be internal as well as external. Internal risk is caused due to
improper product mix, non-availability of raw materials, incompetence to face
competition, absence of strategic management etc
 Internal risk is associated with the efficiency with which a firm conducts its
operations within the broader environment thrust upon it. External business risk
arises due to change in operating conditions caused by conditions thrust upon
the firm which are beyond its control e.g., business cycles, governmental
controls, changes in business laws, international market conditions etc.
 Financial risk refers to the risk of a firm that may not be able to cover its
fixed financial costs. Financial risk is associated with the capital structure of a
company. A company with no debt financing has no financial risk. The extent of
financial risk depends on the leverage of the firm’s capital structure.
Factor # 5. Cash Flow Ability to Service Debt
A firm which shall be able to generate larger and stable

cash inflows can employ more debt in its capital structure as
compared to the one which has unstable and lesser ability to
generate cash inflows. Debt financing implies burden of
fixed charge due to the fixed payment of interest and the
principal.
Whenever a firm wants to raise additional funds, it should
estimate, project its future cash inflows to ensure the
coverage of fixed charges. Debt Service Coverage Ratio and
Interest Coverage Ratio may be calculated for this purpose.
Factor # 6. Nature and Size of a Firm:
 Nature and size of a firm also influence its capital structure. All
public utility concern has different capital structure as compared
to other manufacturing concern. Public utility concerns may
employ more of debt because of stability and regularity of their
earnings.
 On the other hand, a concern which cannot provide stable
earnings due to the nature of its business will have to rely mainly
on equity capital; similarly, small companies have to depend
mainly upon owned capital as it is very difficult for them to raise
long-term loans on reasonable terms and also cannot issue equity
and preference shares at ease to the public.
Factor # 7. Control:
Whenever additional funds are required by a firm, the

management of the firm wants to raise the funds without
any loss of control over the firm. In case the funds are
raised through the issue of equity shares, the control of
the existing shareholders is diluted.
Hence, they might raise the additional funds by way of
fixed interest bearing debt and preference share capital.
Preference shareholders and debenture holders do not
have the voting right.
Factor # 8. Flexibility:
 Capital structure of a firm should be flexible, i.e., it should be

such as to be capable of being adjusted according to the needs of
the changing conditions. It should be possible to raise additional
funds, whenever the need be, without much of difficulty and
delay.
 A firm should arrange its capital structure in such a manner, that
it can substitute one form of financing by another. Redeemable
preference shares and convertible debentures may be preferred
on account of flexibility. Preference shares and debentures
which can be redeemed at the discretion of the firm offer the
highest flexibility in the capital structure.
Factor # 9. Requirements of Investors:
The requirement of investors is another factor that influences the

capital structure of a firm. It is necessary to meet the requirements
of both institutional as well as private investors when debt
financing is used. Investors are generally classified under three
kinds, i.e., bold investors, cautious investors and less cautious
investors.
Bold investors are willing to take all types of risk, are entreprising
in nature, and prefer capital gains and control and hence equity
share capital is best suited to them. Investors who are over-cautious
and conservative prefer safety of investment and stability in returns
and hence debentures would satisfy such overcautious investors.
Factor # 10. Capital Market Conditions:
Capital market conditions do not remain the same forever.

Sometimes there may be depression while at other times
there may be boom in the market. The choice of the
securities is also influenced by the market conditions.
If the share market is depressed and there are pessimistic
business conditions, the company should not issue equity
shares as investors would prefer safety. But in case there is
boom period, it would be advisable to issue equity shares.
Proper timing of issue of securities also saves in costs of
raising funds.
Factor # 11. Assets Structure & Factor # 12. Purpose of Financing:
 Factor # 11. Assets Structure:

 The liquidity and the composition of assets should also be kept in
mind while selecting the capital structure. If fixed assets constitute a
major portion of the total assets of the company, it may be possible
for the company to raise more of long term debts.
 Factor # 12. Purpose of Financing:
 If funds are required for a productive purpose, debt financing is
suitable and the company should issue debentures as interest can be
paid out of the profits generated from the investment. However, if
the funds are required for unproductive purpose or general
development on permanent basis, we should prefer equity capital.
Factor # 13. Period of Finance & Factor # 14. Costs of Floatation:
 Factor # 13. Period of Finance:

 The period for which the finances are required is also an important factor
to be kept in mind while selecting an appropriate capital mix. If the
finances are required for a limited period of, say, seven years, debentures
should be preferred to shares.
 Factor # 14. Costs of Floatation:
 Although not very significant, yet costs of floatation of various kinds of
securities should also be considered while raising funds. The cost of
floating a debt is generally less than the cost of floating an equity and
hence it may persuade the management to raise debt financing. The costs
of floating as a percentage of total funds decrease with the increase in
size of the issue.
Factor # 15. Corporate Tax Rate & Factor # 16. Legal Requirements
Factor # 15. Corporate Tax Rate:

High rate of corporate taxes on profits compel the companies to
prefer debt financing, because interest is allowed to be deducted
while computing taxable profits. On the other hand, dividend on
shares is not an allowable expense for that purpose.
Factor # 16. Legal Requirements:
The Government has also issued certain guidelines for the issue
of shares and debentures. The legal restrictions are very
significant as these lay down a framework within which capital
structure decision has to be made.
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Factors Affecting Capital Structure

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Factors affecting capital structure

Factor # 1. Financial Leverage:

 Factor # 1. Financial Leverage:

 The capital structure of a firm is highly influenced by the growth

A firm which shall be able to generate larger and stable

Whenever additional funds are required by a firm, the

 Capital structure of a firm should be flexible, i.e., it should be

The requirement of investors is another factor that influences the

Capital market conditions do not remain the same forever.

 Factor # 11. Assets Structure:

 Factor # 13. Period of Finance:

Factor # 15. Corporate Tax Rate:

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