Chapter – 17 Capital Structure

1. Chapter Introduction

2. Capital Structure: Introduction

3. Features

4. Factors

5. Cost of Capital



1.   Chapter Introduction:

Finance is an important input for any type of business and is needed for working capital and for permanent investment. The total funds employed in a business are obtained from various sources. Some of the funds are permanently held in the business, such as share capital and reserves (owned funds), some others are held for a long period such as long-term borrowings or debentures, and still some other funds are in the nature of short-term borrowings.

Capital Structure represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, earned revenue, capital surpluses, etc.

2. Capital Structure: Introduction:

Q. What is capital structure and its determinants? Explain the importance of capital structure and planning. (June 00)


Q. "An appropriate capital structure reflects certain features", What are the features? Discuss briefly. (Dec. 01)


What are the salient features of an appropriate capital structure? What are the main factors to be considered when a capital structure decision is taken? (June 99)

The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees, customers, creditors, society in general. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced.

3. Features:

An appropriate capital structure should incorporate the following features:

1. Flexibility: A sound capita1 structure, must be flexible. The consideration of flexibility gives the financial manager ability to alter the firm's capital structure with a minimum cost and delay warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.

2. Profitability: A sound capital structure is also one that also possesses the feature of profitability, i.e., it must be advantageous to the company. It should permit the maximum use of leverage at a minimum cost with the constraints. Thus a sound capital structure tends to minimize 'cost' of financing and maximize earnings per share (EPS).

3. Solvency: A sound capital structure should also have the feature of solvency, i.e., it should use the debt capital only up to the point where significant risk it not added. As has been already observed the use of excessive debt threatens the solvency of the company.

4. Conservation: The capital structure should be conservative in the sense that the debt capacity of the company should not exceed. The debt capacity of a company demands on its ability to generate future cash flows. It should have enough cash to pay creditors fixed charges and principal amount. It should be remembered that cash insolvency might also lead to legal insolvency. ' . -

5. Control: The capital structure should involve minimum risk of loss of control of the company.

A careful consideration of these criteria points the, conflicting nature. For example the use of debt capital is more economical but the same capital adds to the financial risk of the company. As such the emphasis given to each of the elements will differ from one company to another. Also the characteristic features of a company may consider these and additional criteria.

4. Factors:

The various factors affecting the capital structure decision are:

1. Leverage or trading on equity

2. Sales Promotion

3. Management attitudes

4. Assets structure.

5. Cash Flow ability of a company

6. External environment such as the state of capital market, taxation policy, state regulations etc.

7. 'Other factors such as, the size of the business, age of the 'company credit standing, period of finance, lender attitude etc.

1. Leverage or Trading on equity: Trading on equity or leverage refers to the financial process. This enables the owners of a company to enhance their return on equity by borrowing funds for one rate of interest, and using the money to earn a higher rate of return, keeping the different for themselves. It is thus, called making money by using other people's money. Some of the main conclusions regarding the leverage in the capital structure such as use of fixed cost or fixed return sources of finances may be reemphasized. Debts and pre share capital results' into magnifying the earnings per share (EPS) prevailed the firm earns more on the assets purchased with these funds than the cost of their use. Earnings before interest and taxes (EBIT) and EPS relationship are the means to examine the effect of leverage. Out of per share capital and debt,' the leverage impact is felt more in the case of debt because their source of finance costs lower, than per share capital and also the interest payable on, debt is, tax deductible. The use of fixed cost sources of finances also adds to the financial risk of the company and, therefore, it should not be used beyond a point where the amount of fixed commitment charges equals the level of EBIT. To give, up because of its effect on EPS financial leverage is one the important consideration in planning the capital structure for the company.

2. Sales Position: Sales position covers growth rate of future sales and sales stability. The future growth of sales is a measure of the extent to which the earnings per share (EPS) of the rum are likely to be magnified by leverage. The greater the external financially that is usually required. This is so because the likely volatility and uncertainty of future sales have important influences upon the business risk the less equity that should be employed. Similarly, sales stability and debt ratios are directly related, that is, the greater the stability in sales and earnings the greater the debt that should be employed. It is because of this factor that public utilities employ more debt than equity because they are assured of their future sales and earnings.

3. Management Attitudes: Management's attitude concerningc6ntrol of enterprise and risk, involved determine the debt or equity in the capital structure and any analysis of capital structure planning can hardly afford to ignore this factor. In fact every addition of equity unit in the capital structure presents management to participate in the company affairs to that extent. Therefore, while planning capital structure, firms may prefer debt to be assumed of continued control. .

4. Assets Structure: Composition and liquidity of assets may also influence the capital structure decision of the firm. Firms with long lived fixed assets, especially when demand for their output is relatively assured utilities for example - use long-term debt extensively similarly greater the liquidity the more debt that generally can be used all other factors remaining constant. The less liquid the assets of firm the less flexible the firm can be in meeting its fixed charged obligations.

5. Cash flow ability of the company: When considering the appropriate capital structure it is extremely important to analyze the cash flow ability of the firm to serve fixed commitment charges. The fixed commitment charges include payment of interest on debentures and other debts, preference dividend and principal amount. Thus the fixed charged depend upon both the amount of senior securities and the terms of payment. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital with short-term maturity. It is therefore, prudent that for servicing fixed charges at proper time, the management must ensure the availability .of cash because inability on the part of management may result in financial insolvency. Therefore, cash flow analysis is essential to consider while planning appropriate capital structure. Obviously, the greater and more stable the expected future cash flows of the firm, the greater the debt capacity and vice-versa. To be on a safe side the cash flow ability must be determined in the period of depression very carefully.

6. External Environment: Any decision relating to the pattern of capital structure must be made keeping in view the external factors such as state of capital market, taxation policy, state regulations etc. If the capital market is likely to be planned in bearish state and interest rates are expected to decline the management should postponed the debt for the present in order to take advantage of' cheap debt at a larger stage. However, if debt will become costlier and will be on scarce supply owing to bullish trends of the capital market, the management may inject additional doses of debt in capital structure.

Similarly, taxation policy with regard to the various sources of finance affects the capital structure decision of the company. The present taxation provisions are in favor of debt capital because interest payment on debt is a tax-deductible expense. On the contrary dividend payable on equity capital preference share capital is subject to tax state regulation is another exterior factor that must be taken into account while planning capital structure.

7. Other Factors: All the factors specified above are of crucial importance in matters of capital decision. Other factors such as the size of the company, age of the company credit standing of the company, period of finance, tender's attitude, capital structure decisions of competitors etc. are equally important. Smaller companies confront tremendous problem in raising fund and these companies have to pay higher interest on debt and have to agree to inconvenient terms of loan. These companies as a result are compelled to depend heavily on retained earnings and share capital. Similarly age of company plays an important role. New companies face a lot of uncertainty in the initial periods of operation, as they are completely unknown to the suppliers of funds. These companies are compelled to depend upon their own, sources of funds. Small firms or newly started funds have low standing in the market and they are compelled to pay a higher rate of interest on long-term debts. Similarly the period of finance should be paid due attention in the capital structure decision. When funds are required for permanent investment in a company, equity share to capital is preferred. When funds 'are required to finance modernization programs such as overhauling of machines and equipment and aggressive advertising campaign, the company can issue preference share and or debentures. Regardless of management analysis of proper leverage factor for their companies, there is no question but that lender's attitudes are frequently important and sometimes the most important determinant of capital structure. Before adopting a capital structure the management may discuss their with its prospective lenders if possible.1t is also prudent to know about the existing practices regarding the capital structure is radically different from its competitors, there is every need to give careful thought to this duration. Such a departure is unhealthy in the absence of compelling circumstances.

The above-listed factors and difference analysis would help the financial manager to determine within some range the appropriate capital structure. By necessity, the final decision regarding capital structure based on objective analysis supplemented with subjective intuitiveness of the management. In this way, the company shall be able to obtain a capital structure, which has direct influence on maximizing the wealth of shareholders.

Q.State the various factors that affect the capital structure of a company. (Dec. 02)

Please refer to the previous question for details.

Q. What is capital structure? Write down the features of an appropriate capital structure. (Dec. 00)

Please refer to the previous question for details.


5. Cost of Capital:


Q. Write a short note on Cost of Capital (Dec. 02)

Measuring the cost of capital needs a separate treatment. Needless to say, it is desirable to minimize the cost of capital. Hence, cheaper sources should be preferred, other things remaining same.

The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed. A high degree of risk is assumed by shareholders than debt-holders. Debt-holders get a fixed rate of interest but shareholder's dividend is not fixed. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The preference share capital is cheaper than equity capital, but is not as cheap as debt. However, a company should not employ a large amount of debt. Theoretically, a company should have a right mix of debt & equity so that its overall cost of capital is minimum.

  « Chapter – 16 Managing cash Needs Chapter – 18 Dividend Decisions »  

  Posted on Thursday, December 11th, 2008 at 10:43 AM under   Capital Structure | RSS 2.0 Feed

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