Factors influencing Capital Structure

Recently updated on April 13th, 2023 at 06:40 pm

Size of Company: Small companies may have to rely on the founder’s money but as they grow, they will be eligible for long-term financing because larger companies are considered less risky by investors.

Nature of Business: If your business is a monopoly you can go for debentures because your sales can give you adequate profits to pay your debts easily or pay dividends.

The Regularity of Earnings: A firm with large and stable incomes may incur more debt in its capital structure, unlike the one that is unstable.

Conditions of the Money Markets: Capital markets are always changing. You don’t want to issues company shares during a bear market, you do it when there is a bull run.

Government policy: This is important to consider. A change in lending policy may increase your cost of borrowing.

Cost of Floating: The cost of floating equity is much higher than that of floating debt. This may influence the finance manager to take debt financing the cheaper option.

Debt-Equity Ratio: As stated debt is a liability whose interest has to be paid irrespective of earnings. Equity, on the other hand, is shareholders money and payment depend on profits being paid. High debt in the capital structure is risky and may be a problem in adverse times. However, debt is cheaper than issuing shares. Debt interest has some tax deductions that is not the case for dividends paid to equity holders.

Factors influencing

Financial Leverage or 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 the additional profits that equity shares earn because of funds raised by issuing other forms of securities, viz., preference shares and debentures.

It is based on the premise that if the rate of interest on borrowed capital and the rate of dividend on preference capital are lower than the general rate of company’s earnings, the equity shareholders will get advantage in the form of additional profits. Thus, by adopting a judicious mix of long-term loans (debentures) and preference shares with equity shares, return on equity shares can be maximized.

Trading on equity is possible under the following conditions:

(i) The rate of company’s earnings is higher than the rate of interest on debentures and the rate of dividend on preference shares.

(ii) The company’s earnings are stable and regular to afford payment of interest on debentures.

(iii) The company has sufficient assets which can be used as security to raise borrowed funds.

Expected Cash Flows:

Debentures and preference shares are often redeemable, i.e., they are to be paid back after their maturity. The expected cash flows over the years must be sufficient to meet the interest liability on debentures every year and also to return the maturity amount at the end of the term of debentures. Thus, debentures are not suitable for those companies which are likely to have irregular cash flows in future.

Stability of Sales:

Stability of sales turnover enhances the company’s ability to pay interest on debentures. If sales are rising, the company can use more of debt capital as it would be in a position to pay interest. But if sales are unstable or declining, it would not be advisable to employ additional debt capital.

Control over the Company:

The control of a company is entrusted to the Board of Directors elected by the equity shareholders. If the board of directors and shareholders of a company wish to retain control over the company in their hands, they may not allow to issue further equity shares to the public. In such a case, more funds can be raised by issuing preference shares and debentures.

Flexibility of Financial Structure:

A good financial structure should be flexible enough to have scope for expansion or contraction of capitalisation whenever the need arises. In order to bring flexibility, those securities should be issued which can be paid off after a number of years.

Equity shares cannot be paid off during the life time of a company. But redeemable preference shares and debentures can be paid off whenever the company feels necessary. They provide elasticity in the financial plan.

Cost of Floating the Capital:

Cost of raising finance by tapping various sources of finance should be estimated carefully to decide which of the alternatives is the cheapest. Prevailing rate of interest, rate of return expected by the prospective investors, and administrative expenses are the various factors which affect the cost of financing.

Generally, cost of financing by issuing debentures and preference shares for a reputed company is low. It is also essential to consider the floatation costs involved in the issue of shares and debentures, such as printing of prospectus, advertisement, etc.

Period of Financing:

When funds are required for permanent investment in a company, equity share capital is preferred. But when funds are required to finance expansion programme and the management of the company feels that it will be able to redeem the funds within the life-time of the company, it may issue redeemable preference shares and debentures.

Market Conditions:

The conditions prevailing in the capital market influence the determination of the securities to be issued. For instance, during depression, people do not like to take risk and so are not interested in equity shares. But during boom, investors are ready to take risk and invest in equity shares. Therefore, debentures and preference shares which carry a fixed rate of return may be marketed more easily during the periods of low activity.

Types of Investors:

The capital structure is influenced by the likings of the potential investors. Therefore, securities of different kinds and varying denominations are issued to meet the requirements of the prospective investors. Equity shares are issued to attract the people who can take the risk of investment in the company. Debentures and preference shares are issued to attract those people who prefer safety of investment and certainty of return on investment.

Legal Requirements:

The structure of capital of a company is also influenced by the statutory requirements. For instance, banking companies have been prohibited by the Banking Regulation Act to issue any type of securities except equity shares.

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