Capital Structure

Capital Structure:

Once the amount of capitalisation is determined, the next problem is to determine the capital structure of the firm. Capital Structure means determination of the source of finance, i.e., what securities to be issued and in which proportion? Capital Structure represents the relationship and mix of different kinds of long-term funds in the total capital of the company.

Capital structure means the pattern of capital employed in the firm. Capital structure is a financial plan of the firm in which the various sources of capital are mixed in such proportion that it provides a distinct capital structure most suitable for requirement of the firm. Capital structure is the permanent long-term financing that is represented by long-term debt, preference share capital, equity share capital and retained earnings.

Determination of the right proportion in which different securities should be blended is the important task of framing captain structure. Each corporate security has its own advantages and disadvantages. For example- if a firm earns only equity share capital in its capital structure and doesn't use debt capital, in such a situation the firm cannot get the benefits on trading on equity and the bonus of the firm cannot be successful in achieving the objective of maximization of wealth. In contrast to this situation, if firm gives more weights to the debt capital in its capital structure and the earning are highly fluctuating the firm is taking great risk. This type of capital structure is known as high-gearing structure. Therefore, it is very essential that capital structure of a firm should be properly planned. Some of the experts use capitalisation and capital structure as same, but it is wrong. Capitalisation is the quantum of capital necessary for successful operation of the firm and capital structure is the determination of the forms of securities to use to get the required amount of capitalisation.

"Capital Structure refers to the composition of long-term sources of funds such as debentures, debts, preference share capital including reserves and surplus." - I. Pandey

"Capital Structure is the combination of debt and equity securities that comprise a firm's financing of its assets." - J. Hempton

Pattern of Capital structure:

In a newly formed company the pattern of capital structure may be one of the following-

1. Capital Structure with equity shares only.

2. Capital Structure with both equity and preference shares.

3. Capital Structure with equity shares and debentures.

4. Capital Structure with equity shares, preference shares and debentures.

Factors determining capital structure/gearing:

Success of a company largely depends upon the financial plan and capital structure. A company or firm should try to construct an optimum capital structure. The firm should consider all these factors which affects it's capital structure. Generally, factors affecting capital structure are divided into two categories: Internal factors and External factors.

A) Internal factors:

     Following Internal factors are important-  

1. Nature of business:

     Every type of business has its own capital or asset structure. Large manufacturing industries have a very heavy fixed asset based, which serves as security for issue of debentures. While on the other hand trading on light industries having a thin base of fixed assets and suffer from income variations have to rely mostly on ordinary and preference share capital.

2. Regularity and certainty of income:

    Regularity and certainty of income affects capital structure. Debentures are issued if there is certainty of income in future. If funds are needed for sometime then redeemable preference shares may be issued.

3. Desire to control the business:

     If the promoters and founders want to control the business then equity shares are issued and large part is kept in the control of a group of some people and rest of the equity capital is defused in the hands of small investors. When company needs more fund in future, those are obtained through debentures or preference shares.

4. Future plans:

     Future plans should also be kept in view and for this purpose authorised capital should be kept more. Preference shares and debentures should also be part of future plans.

5. Attitude of management:

    Attitude of management greatly affected capital structure. Management varies in skill, judgement, experience, temperament and motivation. It evaluates the same risk differently and it's willingness to employ debt finance also differ. The capital structure therefore is equally influenced by the age, experience, ambition, confidence and conservativeness of the management.

6. Freedom of working:

     If the funds don't want interference in policy formulation and decision making of the firm, the further equity shares to be issued and debentures will be floated.

7. Operating Ratio:

     If operating ratio is very high, then there is less income left for payment of income and dividend. Therefore, in such conditions, there is less scope for debt capital. But, in case of low operating ratio, the firm has more income for interest and dividend and therefore both debentures and equity shares may be issued.

8. Trading on equity:

     If the promoters want to magnify their income, they can resort to debt financing and earn more profit. This is known as trading on equity.

B) External factors:

     Following external factors also affect capital structure:

1. Conditions of capital markets:

    Capital market conditions have significant influence over capital structure. During depression, interest rates are low and profit potentiality is uncertain and irregular. Showing such condition, debentures are more popular. Whereas, during inflation profit potentiality is high. Therefore, demand for ordinary share rise and in such conditions, equity shares are issued and some of them are issued at premium.

2. Nature and type of investors:

     Nature and type of investors affect the capital structure. If investors are ready to take more rest, equity issue is better and if they don't want to take more risk, then debentures are more suited.

3. Cost of capital:

     Each source of capital involves cost. Capital Structure should combine various involving the least average cost of capital and in this way helping in maximizing of return.

4. Legal requirements:

    The Security Exchange Board of India (SEBI) has issued guidelines for issue of shares and debentures. Moreover, there are other legal requirements according to the Companies Act also. Whether a company would be able to meet those requirements or not, it is a matter of consideration, while deciding a capital structure plan.

Financial Leverage

Financial Leverage:

A company can raise its fund from a variety of sources, such as debt, preference share capital and equity capital. The rate of interest on debt is fixed irrespective of the company's Rate of Return (RoR). The company has a legal binding to pay interest on debt. The rate of preference dividend is also fixed but the preference dividends are paid when the company earns profit. The equity shareholders are entitled to the residual income. The rate of equity dividend is not fixed and depend on the dividend policy of the company.

The use of fixed charges source of fund such as debt and preference capital along with the owner's equity in the capital structure is described as financial leverage or trading on equity.

"Financial Leverage exists whenever a firm has debts or other sources of fund that carries fixed charges"

"Ability of a firm to use fixed financial charges to magnify the effects of changes in Earnings before interest and taxes(EBIT) on the firm's earning per share is financial leverage".

The financial leverage can be high or low. If the proportion of fixed cost capital is high, it will have a high financial leverage and if the proportion of variable cost is high, there will be low financial leverage. If a company is having low proportion of variable capital, this solution is also known as trading on equity.

The financial leverage may be favourable or unfavorable. If the cost of borrowed fund is less than the overall return of fund, it will be favourable financial leverage and otherwise, it will be unfavorable financial leverage.

Computation of financial leverage/ measurement of degree of leverage:

Financial Leverage = [EBIT ÷ (EBIT - I)]
                                    =(EBIT ÷ EBT)
                                    =(OP ÷ PBT)

Here,

EBIT= Earnings before interest and taxes

EBT = Earnings before taxes
I       = Interest
OP   = Operating Profit
PBT = Profit Before Taxes

Following 3 situations of capital structure may be there for computation of financial leverage:

1. When there is equity share capital and debt capital.

2. When there is equity share capital and preference share capital.

3. When there is equity share capital, preference share capital and debt capital.

Financing Decisions in International Business

Financing Decision:

The financing objective asserts that the mix of debt and equity selected to finance investment should maximize the value of investment made. Financing Decision consists of raising finance, different financial instruments and obligations attached to it. The finance manager involve in the following financing decisions:

1. Determining the level of gearing.

2. Determining the financing pattern of long-term fund requirements.

3. Determining the financing pattern of medium and short-term fund requirements.

4. Raising of fund through financial instruments like equity shares, preference shares, debentures, bonds, etc.

5. Arrangement of fund from banks and financial institutions for long term, medium term and short-term needs.

6. Arrangement of finance for working capital requirements.

7. Consideration of interest burden of the firm.

8. Taking advantage of interest and depreciation in reducing the tax liability of the firm.

For financing decision, the capital structure is broadly divided into:

a) Equity:

     The raising of fund through issue of shares is known as equity. The shareholders expect the return in the form of dividend. The dividend payments are made only if the distributable profits are available with the company after payment of interest charges and tax payment.

b) Debt:

     The debt funds are raised in the forms of debentures, bonds, term loans etc. The expectation of the provider of debt is to obtain return in the form of interest payments. The interest/debt is repaid as per the agreement. The interest should be paid irrespective of profitability of the firm.