Capital structure refers the way a corporation finances its assets by using a combination of equity, debt, or hybrid securities. A firm’s capital structure is the composition or ‘structure’ of its liabilities. The essence of capital structure decision is to determine the relative proportion of equity and debt.
The equity here in a broader sense means owners’ funds which can be raised by the issue of equity shares and preference shares and by retaining earnings. The debt can be raised by issuing debentures/ bonds or by taking long-term borrowings.
For example, a firm that sells Rs. 20 billion in equity and Rs. 80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The capital structure decision is a significant financial decision because it affects the shareholders’ return and risk and, consequently, the market value of shares. To design capital structure, finance manager should consider the following two assumptions:
- Wealth maximization is attained
- Best approximation to the optimal capital structure
Determinants of Capital Structure
The capital structure decision is the second most crucial decision that a finance manager has to take. The choice of a proper mix of debt and equity depends on the various factors like nature of the product, earnings, stage of growth of the company and management attitude towards control etc.
The following are the main determinants or factors affecting the capital structure of a firm:
- Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of the capital should be capable of earning the revenue enough to meet the cost of capital.
- Management Control: The capital of the business enterprise is also influenced by the intention of the promoters of having effective control. This is also a very important factor in deciding the capital structure. In case management doesn’t want to retain control in few hands, they will raise a large amount of money by issuing debentures and preference shares which hardly enjoy any voting rights.
- Legal Requirements: One has to comply with the provisions of the law in regard to the issue of different types of securities. For example, in order to raise money by issuing shares, company are required to meet the various provisions of SEBI guidelines for a new issue of shares and also provisions of The Companies Act 2013.
- Duration of Finance: Period of finance, i.e., short, medium or long term is also another factor which determines the capital structure of a business enterprise. For example, short-term finances are raised through borrowings as compared to long-term finance which is raised through the issue of shares, stocks etc.
- The Purpose of Financing: The purpose of financing should also be kept in mind in determining the type of financing. The funds may be required either for betterment expenditure or for some productive purposes. The betterment expenditure, being non-productive, may be incurred out of funds raised by issue of shares or from retained profits. On the contrary, funds for productive purposes may be raised through borrowings.
- Economic Conditions: While planning the capital structure, the general economic conditions should be considered. If the economy is in the state of depression, preference will be given to equity form of capital as it involves less amount of risk. But sometimes it is not possible to raise funds by issuing equity as the investors may not be willing to take the risk. Under such circumstances, the company may be required to go for borrowed capital. If the capital market is in boom and the interest rates are likely to decline in further, equity form of capital may be considered immediately, leaving the borrowed form of capital to be tapped in future. It may also be possible to raise more equity capital in the boom as the investors may be ready to take a risk and to invest.
- Tax Policy: The corporate taxation policy of the Government has to be viewed from the angles of corporate taxation and as well as individual taxation. The return on borrowed capital i.e. interest is an allowable deduction for income tax purposes while computing the taxable income of the company. On the other hand, return on equity capital i.e. dividend is not considered like that as it is the appropriation out of the taxable profits. As far as individual taxation is concerned, both interest, as well as a dividend, will be taxable in the hands of an investor of the capital subject to specified deductions available for the purposes.
- Characteristics of Company: Characteristics of the company, in terms of size, age and credit standing play a very important role in deciding capital structure. Very small companies and the companies in their early stages of life have to depend more on the equity capital, as they have limited bargaining capacity, they can’t tap various sources of raising the funds Capital Structure Decision and they do not enjoy the confidence of the investors. Similarly, the companies having good credit standing in the market may be in the position to get the funds from the sources of their choice. But this choice may not be available to the companies having poor credit standing.
- Stability of Earnings: lf the sales and earnings of the company are not likely to be stable enough over a period of time and are likely to be subject to wide fluctuation, the risk factor plays a more important role and the company may not be able to have more borrowed capital in its capital structure as it carries more risk. However, if the earnings and sales of the company are fairly constant and stable over the period of time, it may afford to take the risk, where the cost factor or control factor may play an important role