Unit 3: Capital Structure Decision

What is Capital Structure?

It is a mix of various long term sources of funds used into a
business a long term capital.

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Optimum Capital Structure
Meaning:
The capital structure which is “the most
suitable structure of capital mix for a given
business organization” is known as the
optimum capital structure. To be an optimum
capital structure there are certain
considerations to be taken in account by the
finance manager. Optimum capital structure
differs from business to business and from
time to time it needs changes.
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Optimum Capital Structure
How is the capital the most suitable for an organization?

Business Risk: Business risk comes out of sales and business

operations. Coverage of operating costs and earning profits.
Financial Risk: Financial risk comes out of non-payment of
interest on loans used in the capital structure.
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Important Factors/Considerations for an
Optimum Capital Structure
Following factors contribute to make the
capital structure optimum for a given
concern:
1. Profitability
2. Solvency
3. Flexibility
4. Conservatism
5. Control
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Profitability:
Profitability consideration is achieved
when the components’ and overall cost
of capital (WACC) is optimally lowest
in the capital structure. It leads to
enhancement of profitability in the
organization. For this purpose, the cost
of each source of capital is analyzed
and overall cost of capital is optimized.
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Solvency:
Solvency means that the company should
be able to pay its long term debts easily out
of its available assets. In order to ensure
solvency, the company should ensure that
excess of debt capital should be avoided to
use in its capital structure so that it does not
become difficult to pay the interest on them
and it becomes easy to repay the principal
whenever the company desires.
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Flexibility:
Flexibility means that the finance manager
should always be in a position to alter or
change the debt equity ratio in its capital
structure at any point of time it feel
necessary. The flexibility feature in capital
structure is maintained in order to avoid
risk and optimize the profitability.
Flexibility in the capital structure can be
ensured by employing redeemable capital
in the capital structure.
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Conservatism:
Conservatism here means to “under-utilize
the fund raising capacity of the
organization. This adds to optimacy in the
capital structure by way of maintaining a
positive image of the company in capital
market and at the same time for ensures
that some fund raising capacity is still
available for the business at the time of
financial emergency.
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Control:
Control means the decision making
or voting right of shareholders in
the company. This control of
owners/shareholders should not be
unnecessary diluted by way of
adding more and more equity
capital in the capital structure.
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Optimum Dividend Policy
Meaning:
Optimum dividend policy means that
the company should formulate a
dividend distribution and profit
retention policy which fulfills the
underlying objectives of the company
as well as the objectives of
shareholders of the company. Optimum
dividend policy also differs from
organization to organization.
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Types of Dividend Policies

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Optimum Dividend Policy Considerations
Following consideration contribute in the optimum dividend
policy of the organization:
1. Fulfilling Internal capital requirement of business
2. Meeting the dividend expectations of shareholders
3. Liquidity position of business
4. Fulfilling legal rules/covenants
5. Availing profitable projects
6. Capital market conditions for raising fresh capital
7. Dividend policy of other competitors
8. Prevailing Inflation
9. Past dividend distribution behavior of the company
10. Control of shareholders
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 Optimum Dividend Policy Considerations
1. Internal Capital Requirement of Business
Reasons for capital requirement:
a) Growing business
b) Expanding sales
c) More investment requirement into fixed assets
What to do?
Take the help of dividend policy to distribute less of
dividends to shareholders and retain more in order
to fulfill the above requirements.
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Optimum Dividend Policy Considerations (cont..)
2. Shareholders Expectations
Generally shareholders expect a fairly good return
in the form of cash dividend from the company.
Company is required to study and analyze the
profile of shareholders so that it can know their
expectations with respect to dividend from the
company.
What company should do?
Finance manager of the company is required to
distribute cash dividends fulfilling the requirement
of shareholders. This will the company to build its
external market image of share pricing.

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Optimum Dividend Policy Considerations (cont..)
3. Liquidity position of business
Internal requirement of capital on the one hand is needed for
building the fixed assets and on the other hand the working
capital requirements also increase giving rise to the problem of
liquidity. This liquidity problem may be related to maintaining
more raw materials, more finished goods and more investment
into work in process. There may be more credit sales and more
funds locked in debtors or more cash is required to be
maintained.
What should company do?
The finance manager is required to retain more profits and
compress the cash distribution of dividends in order to fulfill the
liquidity requirements of business.
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Optimum Dividend Policy Considerations (cont..)
4. Fulfilling legal rules or covenants:
Sometimes there is a legal requirement to maintain a given level of
liquidity in order to protect the interest of employees to pay their
salaries easily or to protect the interest of financial institutions to
pay their interest and loans repayment easily. In order to fulfill these
legal bindings the company managers are required to fulfill these
requirements and pay attention to distribute less dividends and retain
more.
5. Availing profitable projects
When company is more progressive it looks for profitable projects
to increase profits. There may be profitable projects available and
the manager may be interested to investment into such projects. At
this time also a compressed dividend distribution and more retention
of profit is required.
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Optimum Dividend Policy Considerations (cont..)
6. Capital market conditions for raising fresh capital
If company is in requirement of fresh of capital and capital
market conditions are not favorable to raise fresh capital then
under this situation more dependence of company comes to
dividend policy. It has to ensure that sufficient profits are retained
so that the fresh capital requirement can be fulfilled out of
dividend policy.
7. Dividend policy of other competitors
The practice of dividend distribution in the industry is also an
important consideration to decide dividend distribution. If it is a
general practice to distribute at least 10% dividend to
shareholders then such minimum level has to be followed
otherwise, a negative image is conveyed in the market.
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Optimum Dividend Policy Considerations (cont..)
8. Prevailing level of inflation
Prevailing level of inflation also gives an idea to the finance
manager about dividend distribution. Prevailing level of
inflation if constant or rising then it is advisable not to
compress dividend distribution to shareholders.
9. Past dividend distribution behavior of the company
This is an important consideration. As per this consideration,
company should meet its past payment of dividend. It is
advised not to lower the past payment at least if not to
increase dividend payment. Because shareholders expect at
least the previous level of dividend payment from the
company.
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Optimum Dividend Policy Considerations (cont..)
10. Dilution of Control of shareholders
Dilution of control of ownership of shareholders means
that voting power of equity shareholders comes into more
shareholders. It happens when number of shareholders
increase without the consent of existing shareholders.
Whenever there is too much of pressure for not
distributing dividend to shareholders and retaining most
of the profits then the alternative left for the company is to
distribute stock dividends or bonus shares. This leads to
dilution of control of shareholders. this is a negative
impact and should be avoided as far possible.

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Stock Dividends or Bonus shares
Stock dividend or bonus shares are distributed in place of cash
dividend to the existing shareholders. Whenever, shareholders
receive the stock dividend they may sell it in the market or
may retain it with them. If they sell it in the market new
shareholders are created.
Benefits of stock dividends or bonus shares:
1. 100% retention of profits possible
2. No cash outflow
3. Helpful in extreme financial crisis
Limitations of Bonus shares:
1. Dilution of ownership
2. Drop in EPS and DPS in future
3. Increased challenge to improve profitability
4. Practice of bonus share cannot be repeated often.
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Concluding Remarks
1. Dividend policy vs. financing decision:
Dividend policy and financing both are helpful in financing. Dividend policy
makes internal financing whereas financing policy provides external financing of
capital.
2. Optimum dividend policy:
Various considerations discussed for dividend policy need to be evaluated
properly and be incorporated properly while formulating an optimum dividend
policy.
3. Avoidance of bonus share:
As far as possible, the distribution of bonus shares be avoided as it increases
challenges for business and is also disliked by the shareholders. Only in case of
extreme financial crisis the issue of bonus shares is recommended.
4. Preference for cash dividend:
It is always recommended to make a distribution of cash dividend as it is an
industry practice and it is expected by shareholders. This practice also gives a
positive impact on the market value of shares.
5. Regular and stable dividend policy:
it is also recommended that the company should distribute dividend regularly and
should ensure that a stability in dividend payment should be maintained.
Regularity and stability are the most desirable aspects of a dividend policy in
order to have the best results.

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