Defining Capital Structure:
A firm for long term finance raises different kinds of securities. Ratio of different kinds of securities is known as capital structure.
The capital structure involves two decisions-
- Types of securities to be issued are preference shares, equity shares and long term borrowings (Debentures).
- Relative ratio of securities can be found by the process of capital gearing. Based on this, companies are divided into two-
- Highly geared companies – Those companies whose proportion of equity capitalization is small.
- Low geared companies – Those companies whose equity capital dominates total capitalization.
For example, we have two companies A and B. Total capitalization amount is 200,000$ in each case. The ratio of equity capital to total capitalization of company A is 50,000$, while in company B, ratio of equity capital is 150,000$ to total capitalization. That means in Company A has a proportion of 25% and company B has a proportion of 75%. In such cases, company A is highly geared company and company B is considered to be a low geared company.
Factors Determining Capital Structure
- Trading on Equity- The word “equity” means the ownership of the company. Trading on equity denotes taking advantage of equity share capital to borrow funds on a reasonable basis. It means additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is less than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a mix of preference shares, equity shares as well as debentures. Equity Trading becomes more critical when shareholders expectations are high.
- Degree of control- In an organization, there are directors who are known as elected representatives of equity shareholders. These members have maximum voting rights when a concern is raised as compared to the debenture holders and preference shareholders. Whereas debenture holders have no voting rights and preference shareholders have less voting rights. If management policies are in such a way that they want to retain their voting rights with them, in that case capital structure consists of debenture holders and loans rather than equity shares.
- Financial plan flexibility – In an enterprise, the capital structure should be such that there are both contractions as well as relaxation in plans. At the right time, debentures and loans can be refunded back. While equity capital cannot be refunded at any point of time, which provides rigidity to plans. Therefore, to make the capital structure work properly, the organisation should go for issuing debentures and other loans.
- Choice of investors- The Company’s policy generally wants to have investors for securities from different categories. So, that a capital structure will be given a chance to all kinds of investors to invest in securities. Risk taking investors generally go for equity shares and loans and low risk taking investors go for debentures.
- Capital market condition- In the entire lifetime of the company, the market price of the shares has got an important role. During boons and inflation, company’s capital should consist of share capital generally equity shares but in depression period, company’s capital structure generally consists of debentures and loans.
- Period of financing- If a company wants to raise finance for a short period, it goes for loans from banks and other institutions, while for a long period it goes for issues of shares and debentures.
- Cost of financing- In a capital structure, the company has to look for cost factors when securities are being raised. When a company is earning profits, debentures seem to be a cheaper source of finance when compared to equity shares because equity shareholders demand an extra share in profits.
- Stability of sales- Companies are in a position to meet fixed commitments when they have a growing market and high sales turnover. Interest on debentures has to be paid irrespective of the profit. When sales are high, profits are high so the company is in a better position to meet such fixed commitments and vice versa. So, equity capital is proven to be safe in such situations.
- Sizes of a company – Small size firms capital structure is pooled from banks, loans and retained profits. On the other hand, big firms go for issuance of debentures and shares, borrowings from financial institutions and loans because of the stability, goodwill, and profitability. The bigger the firm size, the wider will be total captialization.