Capital Structure Capital structure is one of the most complex areas of financial decision making because of its interrelationship

with other financial decision variables. Poor capital structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects—and thereby increasing the value of the firm. “Capital structure is regarded as the proportion of debt and equity” ……..James C Vanhorn “Capital structure is the permanent financing of a firm represented by long-term debt, preferred stock, common stock, but excluding all short-term credit” ……… Weston and Brigham The capital structure involves two decisionsa. Types of securities to be issued are equity shares, preference shares and long term borrowings (Debentures). b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into twoi. Highly geared companies- Those companies whose proportion of equity capitalization is small. ii. Low geared companies- Those companies whose equity capital dominates total capitalization. For instance - There are two companies A and B. Total capitalization amounts to be Tk. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Tk. 5 lakh, while in company B, ratio of equity capital is Tk. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company. So, Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. Optimal capital structure Optimal capital structure means a capital structure where cost of capital is minimum and value of the firm is maximum. Finance manager has to carefully design the capital structure because it affects the overall weighted average cost of capital of the firm and value. If weighted average cost is minimum then the value of the firm will be maximum. “The optimal (best) capital structure is the set of proportions that maximize the total value of the firm”………Schall and Haley

J Gitman Features of an appropriate capital structure Profitability: The most profitable capital structure is one that tends to minimize cost of financing and maximize earning per equity share. Conservation: The debt content in the capital structure should not exceed the limit which the company can bear. The owner’s of closely-held companies are particularly concerned about dilution of control. Capacity: The capital structure should be determined within the debt capacity of the company. The debt capacity of a company depends on its ability to generate future cash flows. Flexibility: The capital structure should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation.Y Khan and P. . Risk: The use of excessive debt threatens the solvency of the company. thereby maximizing the firm’s value is called optimal capital structure” ………L. Control: The capital structure should involve minimum risk of loss of control of the company.K. and this capacity should not be exceeded. It should have enough cash to pay creditor’s fixed charges and principle sum.“The capital structure may be defined as the that capital structure or combinations of debt or equity that leads to maximum value of the firm”…………. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. Return: The capital structure of the company should be most advantageous subject to other considerations it should generate maximum returns to the shareholders without adding cost to them. To the point debt does not add significant risk it should be used otherwise its use should be avoided. Jain “The capital structure at which the weighted average cost of capital is minimized.M.

Management Attitudes: Different management attitudes may bring different changes in capital structure decisions. This is the reason that many firms use much debt because if firm’s tax rate is higher the advantage is also greater. Assets Structure: This factor may affect the capital structure decisions. one having stable sales and other having unstable sales. These factors are given below: Sales Stability: Firms consider this factor at the time of capital structure decisions. It is also possible that the firms relying on external capital may often face greater uncertainty due to which they may reduce their willingness to use debt. Profitability: The factor of profitability also plays an important role in capital structure decisions. because in such a situation management has 50% voting control between the debt and equity. But in a situation when the firm’s financial position is so week that the use of debt may cause serious risk of default then the control considerations could lead to use either debt or equity. The firms which get high rates of return on investment do not use high debt but they use relatively little debt. High rates of return on investment make them able to do financing with internally generated funds. the firm whose sale is relatively stable can safely take on more debt and incur fixed charge in comparison to the firm with unstable sales. A firm having less operating leverage can imply financial leverage in better way as it will have less business risk.Factors Affecting Capital Structure Decisions Capital structure decisions are very important for companies to make. The real state companies usually use general purpose assets as it makes good collateral. Management may be conservatives or aggressive depending upon the attitude towards risk taking. While the companies which are involved in technological research use special purpose assets because they are not highly leveraged. If the management is not in a position to buy or purchase more stock. But there are always some other factors which firms take into consideration while making capital structure decisions. It has been observed that faster growing firms mostly rely on external capital as the flotation costs exceeds. the other option for it is to use debt for new financing. Both managerial styles exercise according to their own judgments and . there are two types of assets which are: general purpose assets and special purpose assets. the utilities companies use more financial leverage than industrial firms because they have stable sales Operating Structure: This is another factor which is involved in making capital structure decisions. For example there are two firms. For instance. Control: There is great affect of control situation on capital structure decisions. Taxes: As far as interest is concerned it is no doubt a deductible expense which is much valuable to firms with high tax rates. Growth Rate: This factor plays an important role in capital structure decision making.

A firm or company makes the decision according to its financial flexibility. . Low rated companies which are in need of capital either go for the stock market or the short-term debt market without taking consideration of target capital structure. They make discussions about the capital structure and mostly act accordingly to their advice. But when its financial position is week the suppliers of capital make funds available if the company gives them a secure position in shape of debt. Seeking all above thoughts in mind it can be said that the companies should maintain the financial flexibility or adequate reserve borrowing capacity because it depends on the factors which are necessary in making capital structure decisions. If the management attitude is conservative it uses less debt. Financial Flexibility: Financial flexibility has also impact on capital structure decision. Lender and Rating Agency Attitudes: Lenders and rating agencies also plays an important role in financial structure decisions.analytical approaches about the proper capital structure. a firm’s optimal capital structure or favorable capital structure depends on long-term and short-term changes. Firm’s Internal Conditions: This is also one of the factors which affect the capital structure decisions. If a firm succeeds in completing any project then the probability of higher returns increase in the near future. So in such conditions the company or firm would give preference to finance with debt till the higher earnings are materialized or reflected in the stock prices. Market Conditions: Capital structure also depends on market conditions. Due to such internal conditions a company would not issue stock because the new earnings are neither anticipated nor reflected in the stock prices. where if the management is having aggressive approach then it uses more debt to get higher profits. If a company is financially good it can raise capital with either stock or bond. The corporations give much importance to the lenders and rating agencies.

a capital structure should give enough choice to all kind of investors to invest. Flexibility of financial plan: In an enterprise. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Stability of sales: An established business which has a growing market and high sales turnover.Factors Determining Capital Structure Trading on Equity: The word “equity” denotes the ownership of the company. thereby the profits are high and company is . Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. equity shareholders are at advantage which means a company should go for a judicious blend of preference shares. Period of financing: When company wants to raise finance for short period. the company’s capital should consist of share capital generally equity shares. While in period of boons and inflation. it is the directors who are so called elected representatives of equity shareholders. in order to make the capital structure possible. Therefore. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings. the capital structure should be such that there is both contractions as well as relaxation in plans. the market price of the shares has got an important influence. the company’s capital structure generally consists of debentures and loans. when sales are high. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. Choice of investors: The Company’s policy generally is to have different categories of investors for securities. During the depression period. Trading on equity becomes more important when expectations of shareholders are high. while for long period it goes for issue of shares and debentures. the company has to look to the factor of cost when securities are raised. Capital market condition: In the lifetime of the company. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. Debentures and loans can be refunded back as the time requires. Cost of financing: In a capital structure. Interest on debentures has to be paid regardless of profit. If the company’s management policies are such that they want to retain their voting rights in their hands. Degree of control: In a company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. the company is in position to meet fixed commitments. the capital structure consists of debenture holders and loans rather than equity shares. Therefore. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore. the company should go for issue of debentures and other loans. equity shares as well as debentures. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. it goes for loans from banks and other institutions.

stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. If company is having unstable sales. big companies having goodwill. then the company is not in position to meet fixed obligations. the wider is total capitalization.in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. While on the other hand. Sizes of a company: Small size business firms capital structure generally consists of loans from banks and retained profits. . So. equity capital proves to be safe in such cases. The bigger the size.

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