Presentation Objectives

•What is Capital Structure? •Principles of Capital Structure •Factors Affecting Capital Structure

Capital structure

refers to the mix of sources from which the long term funds required by a business are raised.

The optimum capital structure is the one which maximizes the market value of share.

Capital Structure

Equity Capital

Debt Capital

Sources of Equity Capital
Common stock Preferred Stock
Sources of Debt Capital Term loans Bonds Hybrid Securities

Retained Earnings

 The

goal of the capital should be to maximize the wealth of the share holders i.e maximizing the long term price per share.


1.Cost Principle

2.Risk Principle
3.Control Principle

4.Flexibility Principle
5.Timing Principle

1.Cost principle

The aim of capital structure should be to minimize the cost of financing and maximize earning per share.

First, the expectations of returns of debt holders are less than those of Equity shareholders. Debt is cheaper Secondly, interest is a deductible expenditure for tax purposes.

2.Risk Ideal capital structure should not principle accept unduly high risk.
Equity: less risky, no contractual payment, the company is not expected to repay the equity capital. Debt: contractual payment of interest and principal irrespective of profit and loss of the company. This leads to the risk of insolvency and brings bad reputation in case of default in repayment.

3.Control principle

Ideal capital structure should keep controlling position of owners intact. Issue of equity shares disturbs the controlling position directly as the control of the residual owners is likely to get diluted. As preference shareholders and holders of debt capital carry limited or no voting rights, they hardly disturb the controlling position of residual owners.

 Ideal

capital structure should be able to cater to additional fund requirements in the future.
the company is risky, the debt will be costly and may contain lot of restrictive clauses like

 If

it will not accept further loan capital or
not to declare dividend beyond certain limit etc,

then it looses flexibility.

 The

ideal capital structure should be able to seize the market opportunities like
period :able to raise equity at good premium. debt at lowest interest rate.

 Boom

 Depression:

 Before

deciding the capital structure of a company one should have a look at various factors ,which affects the capital structure.

 The

factors are: A.Internal B.External and C.General.

Cost factor

Risk factor Internal Factors

Control factor
Objects of Capital Structure Planning

 To  To

maximize the returns to equity shareholders.

issue securities which are easily transferable and marketable. issue the further securities in such a way that the value of shareholding of the present owners is not affected.

 To

External factors

General Economy Conditions
Level of Interest Rates Policy of Lending Institutions Taxation Policy

Statutory Restrictions

(1) General economy Conditions :
 If

the capital market is in boom and the interest rates are likely to decline in further, equity form of capital may be considered immediately, leaving the borrowed form of capital to be tapped in future.

 It

may also be possible to raise more equity capital in boom as the investors may be ready to take risk and to invest.

(2) Level of Interest Rates:

If funds are available in the capital market, only at the higher rates of the interest, the raising of capital in the form of borrowed capital may be delayed till the interest rates become favorable.

(3) Policy of Lending Institutions:

If the policy of term lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital, but the equity capital form should be tapped.

(4) Taxation Policy:

Taxation policy of the Government has to be viewed from the angle of corporate taxation The return on borrowed capital i.e. interest is an allowable deduction for income tax purposes while computing taxable income of the company, while return on equity capital i.e. dividend is not considered like that as it is the appropriation out of the taxable profits.

(5) Statutory Restrictions:

The company has to decide the capital structure within the overall framework prescribed by the Government and various statutes.

Type of Company Characteristics of Company General factors Stability of Earnings

Attitude of the Management

1.Type of company:
 If

company is private limited company, the control of management is of paramount importance. company is public limited company, cost factor will be more important.

 If

2.Characteristics of the company
 Very

small companies do not have bargaining power and may have to depend on equities in the beginning as they do not enjoy the confidence of the lenders. having good credit standing in the market, may be in the position to get the funds from the sources of their choice.

 Companies

3.Stability of Earnings
 Companies

who have stability of earning can have better bargaining power. They can borrow cheap and can take risk.

 If

earning in not stable, the company may not be able to have more borrowed capital in its capital structure as it carries more risk. Then equity is better as it does not have contractual obligation.

4.Attitude of management
 If

attitude of management is conservative, the risk factor becomes more important and equity is preferred. aggressive, the cost factor become more important and debt will be preferable.

 If

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