THE SAINT AUGUSTINE UNIVERSITY OF TANZANIA

TYPE OF ASSIGNMENT INDIVIDUAL ASSIGNMENT

NAME JOHN, ISACK .J
REG. NUMBE PGDAF 77862
COURSE PGDAF
SUBJECT CORPORATE FINANCE
SUBJECT CODE FI 500
LECTURE NAME MRAWA DANIEL
DATEOF SUBMISSION WEDNESDAY12 2020

QUESTION
Explain factors determine capital structure

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Introduction
The capital structure of a company is a particular combination of debt, equity and other sources of
finance that it uses to fund its long-term asset. The key division in capital structure is between debt
and equity. The proportion of debt funding is measured by gearing or leverages. There are different
factors that affect a firm's capital structure, and a firm should attempt to determine what its optimal
or best mix of financing.
Initially, at the time of promotion of company, capital structure plan is to be prepared very carefully.
First of all, the objective of the capital structure should be determined and then the financing
decisions should be taken accordingly. Company has to arrange for funds for its activities
continuously.Every time when the funds are to be procured, financial manager has to choose the
most profitable source of finance after considering the merits and demerits of different sources of
finance. Therefore, capital structure decisions have to be taken on continuous basis.

Size of Business:
Small businesses have to face great difficulty in raising long-term finance. If, it is at all able to get
long-term loan, it has to accept unreasonable conditions and has high rate of interest. Such
restrictive conditions make the capital structure inflexible for small companies and management
cannot freely run the business.
Therefore, small businesses rely on share capital and retained earnings to meet their requirements of
long-term funds. Small companies have to bear greater cost of raising long-term funds as compared
to large companies. Besides, issuing ordinary shares every time to raise long-term funds may result
in loss of control by existing shareholders.
The shares of a small company are not widely held and the dissatisfied class of shareholders can
easily organise to keep the control in their hands. Therefore, small companies do not allow to
expand their business much and manage their funds out of retained earnings. Large companies are
able to raise their long-term loans at comparatively cheaper terms and can issue ordinary shares and
preference shares to the public.
Due to issuance of shares of high amount, the cost of issue is low in comparison to small
companies. Therefore, while preparing capital structure plan, company should make proper use of
its size.

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Stage of Life Cycle:
Stage of the life cycle of a firm is also an important factor affecting the capital structure. If a firm is
in its initial stages, there are more chances of its failure. In such case, the use of ordinary share
capital should be emphasised. Firm can work properly if it does not issue such securities on which it
has to pay fixed amount of interest.
In such case, the risk is high. When a firm is passing through the stage of growth, it should plan its
capital structure in a manner that it can raise finance easily whenever it needs. When a firm enters
the stage of maturity, it has to spend more on the development of new products and, therefore, funds
should be raised from ordinary shares because there is uncertainty in the increase in income of
business.
If in the long-run, there is possibility of reduction in level of business activities, the plan of capital
structure should be prepared in a manner so as to facilitate the repayment of surplus funds.

Corporation Tax:
Due to the current provisions of tax, the use of debt in the capital structure is cheaper as compared
to the ordinary share capital or preference share capital. Interest is chargeable expense from the
taxable income, whereas dividend is paid out of earnings available after tax. Hence, level of tax
affects the cost of capital.
Therefore, to take the advantages of trading on equity, management uses more loan capital in the
capital structure which helps in increasing the income of the shareholders. Forexaple it is clear that
by use of 6% debentures, the profit available for equity shareholders is Tzs. 33,000 and by using 6%
preferred stock, this income is only Tzs. 6000. Thus, ordinary shareholders have an additional
income of Tzs. 27,000 (Tzs .33,000- Tzs. 6,000) due to income tax.
In the same manner, if the shareholders come under high income tax bracket, the company meets its
financial requirements by retaining a major part of its income. On the other hand, if the shareholders
fall in low income tax bracket, they will like to get high dividend and in such case the company will
meet its financial requirements from external sources

Trading on Equity:
To arrange funds for acquiring company’s assets, the use of fixed cost sources like debt and
preference share capital is called trading on equity or financial leverage. If the return on assets
acquired from the debt funds is greater than the cost of debt, the earnings per share will increase.

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The income will also increase by the use of preference share capital but it will increase more by the
use of debt funds because interest is allowed as an expense from the taxable income. Because of its
effect on the earnings per share, financial leverage is an important factor in planning the capital
structure.
The greater the earnings per share (EPS), more profitable it will be for the ordinary shareholders. To
calculate the effect of leverage on EPS and earnings before interest and taxes (EBIT), analysis must
be made by the management among the alternative sources of funds. If the interest and earnings
before tax are increasing, EPS will increase by the use of more debt. Therefore, a company should
use such sources of finance which lead to the maximisation of EPS.

Cash Flow Ability of the Company:

Sometimes, the interest coverage ratio of a company is high but it does not have adequate cash to
pay interest or preference dividend. Due to this reason, company can be financially insolvent.
Therefore, a company must have so much cash balance that it can pay its fixed charges in time.
The amount of fixed charges will be greater if a company uses more debt financing or preference
share capital. Higher the efficiency of cash flow, more will be its ability to use debt funds.
Therefore, whenever a company thinks of using additional debt, it must analyse its capacity of
generating cash flows to pay the fixed charges.
The companies which foresee higher possibility of more and stable cash inflows in future, can use
more debt in their capital structure. The capacity of the firm to pay fixed charges and generate cash
flows can be determined by calculating the ratio of net cash inflows to fixed charges. The greater
this ratio, the higher will be debt capacity of the firm.

Cost of Capital:
The cost of a source of finance is the minimum rate of return expected by its suppliers. The
expected rate will depend upon the risk borne by the investors. Ordinary shareholders bear the
maximum risk because no rate of dividend is fixed for them and the dividend is paid after the
payment of interest and preference dividend.
The payment of interest on debentures is a statutory liability of the company whether the company
earns profits or not. Therefore, debt is cheaper as compared to ordinary share capital. Cost of debt
becomes lesser because interest is a charge on the taxable income.

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But it should be kept in mind that debt can be cheaper only upto a particular point and the company
cannot always decrease the overall cost of capital by using debt. Later, debt can be costly because
use of more debt raises the risk for both the creditors and the shareholders.
When the quantum of risk increases, creditors are not ready to provide loans. If at all they agree,
they demand higher rate of interest. Similarly, ordinary shareholders also expect higher dividend
due to the use of more debt finance and thus, cost of share capital increases. All this decreases the
market price of the shares.
If share capital and retained earnings are compared, the cost of retained earnings will be lower
because, on the one hand, it has no issue expenses and on the other, shareholders will not have to
pay personal income tax on the retained earnings which otherwise was payable on dividends.

Control:
In present times, management wants to maintain its existence continuously and does not want any
outside interference. Ordinary shareholders have got legal right to appoint directors. If the company
is paying interest and instalment of loan in time, the creditors of company can’t interfere in
managerial decisions.
Similarly, preference shareholders do not have voting right. But in case the company is unable to
pay dividend to the preference shareholders for certain period of time, the preference shareholders
get a right to participate in the meetings of the company. Thus, in most of the circumstances,
ordinary shareholders have the right to appoint directors.
If the main objective of the management is to keep control in the existing hands, it will raise
additional finance from debt and preference shares because it will not adversely affect its control.
But if company takes loan more than its capacity and is unable to pay interest and principal amount
in time, creditors can take the control of company in their hands and the control of company can be
taken away from the present management.
In such case, issue of ordinary shares would be fair. In closely held company, the element of control
becomes more significant. A shareholder or a class of shareholders can take the control of the
company in its hands by buying all or almost all the shares of fresh issue. Therefore, these
companies issue debt capital or preference share capital to avoid the risk of loss of control.
If these companies are able to widely spread the issue, there is no risk of loss of control. In case of
widely held companies, there is no risk of loss of control by issuing new shares because their
shareholders are widely spread. Most of the shareholders have interest in the returns; they do not
have time to participate in the meetings of the company.
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General Level of Business Activity:
If an economy is recovering from depression, the business activities in the country will expand. The
possibilities of development of business will increase due to it. As a result, company may require
additional funds in future. In such cases, management should give more importance to the flexibility
of capital structure so that it may be able to raise funds from alternate sources to meet its needs. The
company, in such situation, should issue ordinary share capital rather than debt.
From the above it is clear that various factors affect the capital structure. Some of them are self-
contradictory. For example- from the view point of cost of capital, a company should use more debt
because it is cheaper source as compared to others. But use of more debt increases financial risk and
flexibility for management comes down.
From the viewpoint of flexibility, firm should use more ordinary share capital. Therefore, a financial
manger should take capital structure decision by establishing a proper balance among all these
factors.

Degree of Competition:
If in an industry, the degree for competition is high, such companies in that industry should use
greater degree of share capital as compared to the debt capital. On the other hand, the industries in
which the degree of competition is not so high, have a tendency of stable income and, therefore,
they can use more debt.

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Conclution
Capital structure decisions are affected by many factors and as we above factors, determining
optimal capital structure is not an exact science. So, even companies in the same industry can have
significantly different structures of capital, this may be due to external factors or company internal
factors company also goes through a number of stages in its lifecycle and to assess company’s
capital, it’s crucial to understand which stage it’s on at the moment. Companies usually attract only
equity capital when they start doing business because lack of collateral and credit history gives few
options to attract investors. But using borrowed funds helps to speed up business development
significantly because accumulating profit is a lengthy process. Such economy in time helps grow
company quicker and maximize profit.

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REFFERENCES

1 Westone, J.F, Brigham, E.F & Beslay. S; (1996) Essential of the managerial finance (11
ed).Dryden press

2. Arnold,G.(2005).Corporate financial management(3 ed).financial times


3. Ross, S.A.,Westerfield, R.W.,Jordan, B.D (2001) Essential of corporate finance (3 ed)

4. Denzel, W.,Antony, H(2001)Corporate finance principles &practice(2 ed) financial times