Define capital structure. What is optimum capital structure? Discuss the various factors affecting the capital structure.

 Define capital structure. What is optimum capital structure? Discuss the various factors affecting the capital structure.

Ans. A firm needs to have such sources in the right proportion. Short-term funds keep varying and hence, their proportions cannot be laid down in a rigid manner. However, a more definite policy is required for the composition of the long-term funds. This forms the capital structure of the firm. Thus, the capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company.

More important areas of the policy are the debt-equity ratio and the dividend decision. The latter affects the building up of retained earnings which is an important component of long-term owned funds. Since the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision, the term financial structure is often used to mean the capital structure of the firm.

According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.

With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firm’s objective.

The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firm’s value through the earnings available to the shareholders.The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the company’s market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the Earnings Per Share (EPS).

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum.

Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm.

Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:

1.  Maximize the value of the firm.

2.  Minimize the overall cost of capital.

Forms of Capital Structure

Capital structure pattern varies from company to company and the availability of finance. Normally the following forms of capital structure are popular in practice.

•    Equity shares only.

•    Equity and preference shares only.

•    Equity and Debentures only.

•    Equity shares, preference shares and debentures.

Features of an Ideal Capital Structure

How do you choose a particular type of capital structure? The decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency.

Capital structure of the company should be such that the company derives maximum benefits from it and is able to adjust it easily to changing conditions. Companies aim to find an appropriate proportion of different types of capital which will minimise the cost of capital and maximise the market value. Optimum or balanced capital structure means an ideal combination of borrowed and owned capital that may attain the marginal goal, i.e., maximisation of market value per share or minimisation of cost of capital. The market value will be maximised or the cost of capital will be minimised when the real cost of each source of funds is the same. It is a formidable task for the financial manager to determine the combination of the various sources of long-term finance. Thus, capital structure is usually planned keeping in view the interests of the ordinary shareholders.

The ordinary shareholders are the ultimate owners of the company and have the right to elect the directors. While developing an appropriate capital structure for his or her company, the financial manager should aim at maximising the long-term market price of equity shares.

Let us now discuss these features in detail.

Profitability

The firm should make maximum use of leverage at a minimum cost.

Flexibility

An ideal capital structure should be flexible enough to adapt to changing conditions. It should be in a position to raise funds at the shortest possible time and also repay the money it borrowed, if they appear to be expensive.

This is possible only if the company’s lenders have not put forth any conditions like restricting the company from taking further loans, restricting the usage of assets, or restricting early repayments. In other words, the finance authorities should have the power to take decisions as circumstances

warrant.

Control

The structure should have minimum dilution of control.

Solvency

Use of excessive debt threatens the very existence of the company. Additional debt involves huge repayments. Loans with high interest rates must be avoided even if some investment proposals look attractive. Some companies who resort to issue of equity shares to repay their debt for equity holders do not have a fixed rate of dividend.

Factors Affecting Capital Structure

Capital structure should be planned at the time a company is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure, and the subsequent financing decisions should be made with a view to achieve the target capital structure.

Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a

firm needs additional finance.

The major factor affecting the capital structure is leverage. There are also a few other factors affecting them. All the factors are explained briefly here.

Leverage

The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans from banks and financial institutions, and debentures in the capital structure, is known as “trading on equity” or “financial leverage”.

If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase without an increase in the owner’s investment. Similarly, the EPS will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because of the following reasons:

 The cost of debt is usually lower than the cost of preference share capital

 The interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not The companies with high level of Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholder’s equity.Debt-equity ratio is another parameter that comes into play here. Debt-equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long-term and short-term debt, and this is represented as debt/equity. Creditors insist on a debt-equity ratio of 2:1 for medium-sized and large-sized companies, while they insist on 3:1 ratio for Small Scale Industries (SSI).

A debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered as a healthy ratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering companies.

Generally, in debt-equity ratio, the lower the ratio, the higher is the element of uncertainty in the minds of lenders. Increased use of leverage increases commitments of the company (the outflows being in the nature of higher interest and principal repayments), thereby increasing the risk of the equity shareholders.

The other factors to be considered before deciding on an ideal capital structure are:

 Cost of capital – High cost funds should be avoided. However attractive an investment proposition may look like, the profits earned may be eaten away by interest repayments.

 Cash flow projections of the company – Decisions should be taken in the light of cash flow projected for the next 3-5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any profits after 2 years.

 Dilution of control – The top management should have the flexibility to take appropriate decisions at the right time. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control, the companies may issue preference shares or raise debt capital. An excessive amount of debt may also cause bankruptcy, which means a complete loss of control. The capital structure planned should be one in this direction.

 Floatation costs – Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of

floatation costs. Such costs should be compared with the profits and right decisions should be taken.