What is Capital Structure? What are the internal and external factors influencing Capital Structure?

Answer: Capital Structure & Internal and External influencing Capital Structure.

Meaning –

Capital Structure constitutes two words i.e. Capital and Structure. The word ‘capital’ refers to the investment of funds in business while ‘structure’ means arrangement of different components in proper proportion. Capital structure means ‘financing mix’. It refers to the proportion of different securities raised by a firm for long term finance.

Factors influencing Capital Structure:

The factors which play a vital role in determining the capital structure are divided into two categories viz. Internal Factors and External Factors.

A. Internal Factors:

I. Size and Nature of Business:

The size of business has great impact on its capital structure. Trading concerns raise capital by issue of equity as well as preference shares as they require more working capital. Small companies have limited capacity to raise funds from external sources.  Large companies possess huge investments; hence they can issue debentures by offering securities of fixed assets such as land, building, machinery etc.

Such companies prefer to raise funds by issuing equity shares along with debentures.

ii . Capital Gearing:

The ratio between debt capital (fixed interest) and equity capital (variable dividend) is called capital gearing. It is high gearing when the proportion of debt capital is high than the equity share capital while it is low gearing when the proportion of debt capital is low than the equity share capital. In order to protect the interest of equity shareholders, the company usually uses proper mix of various types of securities in its capital structure.

iii. Requirement of Capital:

In the initial stages of business, a company cannot issue varieties of securities as there is considerable risk involved and hence, it is preferable to raise capital through equity shares. Later on for expansion or modernization, the company may issue other types of securities such as debentures, public deposits etc.

iv. Adequate Earnings and Cash Position:

Developed companies with stable earnings (stable cash flow) utilize large amount of debt capital in their capital structure as they can pay a fixed rate of interest.
 Companies with unstable earnings (unpredictable cash flow) should not opt for debt in their capital structure as they may face difficulty in paying the fixed amount of interest.

v. Future Plans and Development:

Capital structure is designed by the management keeping in mind the future development and expansion plans. Equity shares can be issued in the initial stages whereas debentures and preference shares may be issued in future to finance developmental plans.

vi. Period of Finance:

While framing capital structure, the ‘period for which finance is needed’ must also be
considered. If funds are required on regular basis, the company should raise it through issue of equity shares. For a shorter period, funds can be raised through issue of debentures or preference shares.

vii. Trading on Equity:

The use of borrowed capital for financing a firm is known as Trading on Equity.
If the rate of interest on debt is lower than the rate of earnings of the company, the equity shareholders get additional dividend. This increases the creditworthiness of the company and the company is able to raise further loan at a lower rate of interest.

On the other hand, if the company’s earnings are not sufficient, it may lead to financial crisis as the interest on debt has to be paid even in case of loss. The entire earnings may exhaust in payment of interest. In this case, no dividend can be declared by the company. If no dividend is paid on equity shares, it adversely affects the creditworthiness of the company.

Thus, trading on equity is double edged sword. It may increase the income of the shareholder if things head in a proper direction. On the other hand, it increases the risk of loss under unfavourable conditions.

viii. Attitude of Management:

Capital structure is influenced by the attitude of the persons in the management. If the management wishes to have exclusive control, they raise capital through preference shares and debt capital. Since the holder of such shares do not enjoy any voting rights, thereby cannot interfere in the management of the company.

ix. Growth of Business Firm:

Capital requirement of a firm depends upon the stage of development. At the initial stage, the source of finance is mostly equity shares and short term loans. As the stage progresses, the requirement increases and funds are procured by issuing debentures and preference shares.

B. External Factors: 

i. Market Conditions:

Various methods of financing should be considered depending upon the prevailing market conditions. If the share market is in a declining situation, the company should raise funds by issuing debts.

On the other hand, during the period of boom in the share market, the company should raise funds by issuing equity shares.

ii. Attitude of Investors:

Attitude of investors also plays an important role in determination of capital structure. If the investors prefer to take risk and expect higher returns, they invest in equity shares. If the investors prefer to earn safe and assured income and are not ready to take risk, they invest in preference shares and/or debentures.

iii. Government Rules and Regulations:

According to SEBI, the normal debt equity ratio is 2 : 1. However, in case of large capital intensive projects, the permitted ratio is 3 : 1. Government provides aid and concessions to small industrial projects to raise more debt capital.

iv. Rate of Interest:

Capital structure depends upon the rate of interest prevailing in the market. If the rate of interest is higher, firms delay debt financing. Conversely, if the rate of interest is lower, firms will opt for debt financing.

v. Competition:

The company which faces cut‐throat competition should raise funds by issuing equity shares as their earnings are not certain and adequate.

However, the company which has a monopoly position in the market may issue debt capital because of certainty of earnings.

vi. Cost of Capital:

Cost of capital is the minimum return expected by its supplier/investor. The expected return depends upon the degree of risk. In case of debt holder, rate of interest is fixed and the loan is repaid within the prescribed period. A high degree of risk is assumed by equity shareholders than the debt holders. In case of shareholders, rate of dividend is not fixed and their capital is repaid only when the company is liquidated. Thus, debt is a cheaper source of capital than equity. The preference share capital is also cheaper but not cheap as debt.

However, the company cannot minimize cost of capital by employing only debt. As debt becomes more expensive beyond a particular point due to the increased risk of
excessive debt.

vii. Attitude of Financial Institutions:

Attitude of financial institutions is to be considered while determining capital structure. If financial institutions prescribe high terms of lending, then the company should move to other source of financing.

However, if financial institutions prescribe easy terms of lending, the company should obtain funds from such institutions.

viii. Taxation:

Interest paid against debt is tax deductable expenditure whereas dividend is not considered as tax deductable expenditure for the company.

Hence, issue of debt capital is more preferable than issue of share capital. The companies with higher taxes employ debt capital as it is a tax deductable expense.

What is Working Capital? State factors affecting requirement of working capital.

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