Factors Determining the Capital Structure Part 5

Download PDF of This Page (Size: 294K)

You have learnt that the mix of debt and equity used (called the capital structure) for meeting the capital requirements of a company affects the rate of return on owners’ capital (shareholders’ funds). This in turn, determines the earnings per equity share (EPS) and has its effect on the market value of company’s shares. Hence, the choice of an appropriate capital structure becomes a very important decision for the finance manager of any company. He should make this decision on the basis of reliable data and after careful analysis of all the factors that influence this choice.

Image of Factors Determining The capital Structure

Image of Factors Determining the Capital Structure

Image of Factors Determining The capital Structure

Expected Earnings and Their Stability

If the expected earnings, in terms of rate of return on the amount to be invested are sufficiently large, use of debt is considered quite desirable. Not only that, the stability of earnings should also be taken into account because if the firm is engaged is business activities in which sales and profits are subject to wide fluctuations, it will be risky to use higher proportion of debt.

Cost of Debt

If the rate of interest on borrowings is lower than the expected rate of return on capital employed, then debt may be preferred. With lower cost of debt financing, the overall cost of financing is reduced and the return on equity capital will be higher, as explained earlier.

Right to Manage the Business

Debenture holders and preference shareholders do not have much say in management of the company. This authority lies primarily with the equity shareholders who have the voting rights. Hence, while deciding on the mix of equity and debt, the promoters/ existing management of the company may also take into account the possible effect of raising funds through equity shares on the right to control the business.

Capital Market Conditions

The conditions in the capital market also influence the capital structure decision. At times capital market is so depressed that the investors are unwilling to subscribe to shares. In such a situation, it is considered better to rely on debt or defer the decision till a favourable market condition is restored.

Regulatory Norms

While deciding on the capital structure, the legal constraints like the limit on debt-equity ratio should also be kept in view. At present, such limit is 2:1 in most cases. This implies that at any point of time, the debt should not be more than twice the amount of share capital. This limit keeps on changing with changing economic environment and varies from industry to industry.

Flexibility

The planned capital structure should be flexible enough to raise additional funds without much difficulty. The company should be able to raise additional capital in the form of debt or equity whenever required. But if the company’s capital structure has too much debt, then the lends may not be able to give more loan to the company. In a such a situation it may be forced to raise the funds only through shares for which the capital market condition may not be conducive.

Investors’ Attitude Towards Investment

While planning the capital structure of a company one must bear in mind that all investors do not have the same attitude towards their investment. Some are highly conservative who prefer safety to return. For such investors, debentures are considered most suitable. As against this, there are some who are interested in high return on their investments and are ready to take the risk involved. Such investors prefer equity shares. Then, there are many who are willing to take a limited risk provided the return is better than the rate on secured debentures and bonds. Preference shares are most suitable for this category of investors. In order to attract all categories of investors, it is considered more desirable to issue different types of securities specially when the amount of capital requirement is large.

  • Looking at the above considerations, it can be safely concluded that an appropriate capital structure is one which:

  • Ensures maximum return on equity by making use of the leverage effect within reasonable limits of the risk involved;

  • Caters to all types of investors by using a judicious mix of different types of securities;

  • Has the necessary flexibility to make required reduction or addition to funds, according to changed conditions;

  • Involves minimum risk of dilution in control of the company affairs by the existing group of shareholders; and

  • Fully keeps in view the legal constraints and the prevailing capital market conditions.

  • To sum up, the most judicious capital structure is one that minimises the cost of funds and maximises the shareholders wealth. In financial management terminology, such a capital structure is called optimal capital structure.

Dividend

You know that in every business unit the amount of profit earned (or loss incurred) during a financial year is ascertained and distributed among its owners. In case of a

proprietary concern, the whole amount of profit or loss so ascertained is added to proprietor’s capital and whatever amount is withdrawn by him is termed as drawings and is deducted from his capital. Similarly, in case of a partnership firm the profit or loss is distributed among the partners in their agreed profit-sharing ratio and included in their capital. Whatever amount is withdrawn by the partners is deducted from their respective capitals as drawings. In case of a company, however, it is dealt with differently. First of all, we work out the operating profits (called PBIT – Profit before interest and tax). Then deduct the amount of interest on loans therefrom and arrive at the amount of profits before tax (PBT). Then we deduct the amount of tax on the company’s profits as per rules and ascertain the profit after tax (PAT). This is the amount of profit which is available for distribution among the shareholders. As a matter of practice and financial prudence, the whole amount of profit earned by the company is never distributed to the shareholders. A substantial part of it, is retained for meeting company’s future financial needs. The amount of profits so retained is called ‘retained earnings’ and the amount profit distributed to the shareholders is called as ‘dividend’. It may be noted that the dividend paid to preference shareholders is called ‘preference dividend’ and the dividend paid to equity shareholders is called ‘equity dividend’.

Developed by: