According to Gerestenberg, ‘capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and bonds’.
Keown et al. defined capital structure as, ‘balancing the array of funds sources in a proper manner, i.e. in relative magnitude or in proportions’.
In the words of P. Chandra, ‘capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders’.
Concept of Capital Structure
The relative proportion of various sources of funds used in a business is termed as financial structure. Capital structure is a part of the financial structure and refers to the proportion of the various long-term sources of financing. It is concerned with making the array of the sources of the funds in a proper manner, which is in relative magnitude and proportion.
The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.
Again, each component of capital structure has a different cost to the firm. In case of companies, it is financed from various sources. In proprietary concerns, usually, the capital employed, is wholly contributed by its owners. In this context, capital refers to the total of funds supplied by both—owners and long-term creditors.
Importance of Capital Structure
(i) Value Maximization
Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.
(ii) Cost Minimization
Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.
(iii) Increase in Share Price
Capital structure maximizes the company’s market price of share by increasing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.
(iv) Investment Opportunity
Capital structure increases the ability of the company to find new wealth- creating investment opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.
(v) Growth of the Country
Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.
Factors Affecting Capital Structure
1. Cash Flow Position
The decision related to composition of capital structure also depends upon the ability of business to generate enough cash flow.
The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend to preference shares and principal and interest amount for loan. Sometimes company makes sufficient profit but it is not able to generate cash inflow for making payments.
The expected cash flow must match with the obligation of making payments because if company fails to make fixed payment it may face insolvency. Before including the debt in capital structure company must analyse properly the liquidity of its working capital.
A company employs more of debt securities in its capital structure if company is sure of generating enough cash inflow whereas if there is shortage of cash then it must employ more of equity in its capital structure as there is no liability of company to pay its equity shareholders.
2. Interest Coverage Ratio (ICR)
It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest payment obligation.
ICR= EBIT/ Interest
High ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities.
3. Debt Service Coverage Ratio (DSCR)
It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR takes care of return of interest as well as principal repayment.
If DSCR is high then company can have more debt in capital structure as high DSCR indicates ability of company to repay its debt but if DSCR is less then company must avoid debt and depend upon equity capital only.
4. Return on Investment
Return on investment is another crucial factor which helps in deciding the capital structure. If return on investment is more than rate of interest then company must prefer debt in its capital structure whereas if return on investment is less than rate of interest to be paid on debt, then company should avoid debt and rely on equity capital. This point is explained earlier also in financial gearing by giving examples.
5. Cost of Debt
If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to equity.
6. Tax Rate
High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from income before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high end tax rate means prefer debt whereas at low tax rate we can prefer equity in capital structure.
7. Cost of Equity
Another factor which helps in deciding capital structure is cost of equity. Owners or equity shareholders expect a return on their investment i.e., earning per share. As far as debt is increasing earnings per share (EPS), then we can include it in capital structure but when EPS starts decreasing with inclusion of debt then we must depend upon equity share capital only.
8. Floatation Costs
Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost of advertisement, underwriting statutory fees etc. It is a major consideration for small companies but even large companies cannot ignore this factor because along with cost there are many legal formalities to be completed before entering into capital market. Issue of shares, debentures requires more formalities as well as more floatation cost. Whereas there is less cost involved in raising capital by loans or advances.
9. Risk Consideration
Financial risk refers to a position when a company is unable to meet its fixed financial charges such as interest, preference dividend, payment to creditors etc. Apart from financial risk business has some operating risk also. It depends upon operating cost; higher operating cost means higher business risk. The total risk depends upon both financial as well as business risk.
If firm’s business risk is low then it can raise more capital by issue of debt securities whereas at the time of high business risk it should depend upon equity.
Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances.
The equity shareholders are considered as the owners of the company and they have complete control over the company. They take all the important decisions for managing the company. The debenture holders have no say in the management and preference shareholders have limited right to vote in the annual general meeting. So the total control of the company lies in the hands of equity shareholders.
If the owners and existing shareholders want to have complete control over the company, they must employ more of debt securities in the capital structure because if more of equity shares are issued then another shareholder or a group of shareholders may purchase many shares and gain control over the company.
Equity shareholders select the directors who constitute the Board of Directors and Board has the responsibility and power of managing the company. So if another group of shareholders gets more shares then chance of losing control is more.
Debt suppliers do not have voting rights but if large amount of debt is given then debt-holders may put certain terms and conditions on the company such as restriction on payment of dividend, undertake more loans, investment in long term funds etc. So company must keep in mind type of debt securities to be issued. If existing shareholders want complete control then they should prefer debt, loans of small amount, etc. If they don’t mind sharing the control then they may go for equity shares also.
12. Regulatory Framework
Issues of shares and debentures have to be done within the SEBI guidelines and for taking loans. Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy then companies may prefer issue of securities for additional capital whereas if monetary policies are more flexible then they may go for more of loans.
13. Stock Market Condition
There are two main conditions of market, i.e., Boom condition. These conditions affect the capital structure specially when company is planning to raise additional capital. Depending upon the market condition the investors may be more careful in their dealings.
During depression period in the market business is slow and investors also hesitate to take risk so at this time it is advisable to issue borrowed fund securities as these are less risky and ensure fixed
repayment and regular payment of interest but if there is Boom period, business is flourishing and investors also take risk and prefer to invest in equity shares to earn more in the form of dividend.
14. Capital Structure of other Companies
Some companies frame their capital structure according to Industrial norms. But proper care must be taken as blindly following Industrial norms may lead to financial risk. If firm cannot afford high risk it should not raise more debt only because other firms are raising.