Capital Structure Definition – Factors Determining Capital Structure

capital structure

Capital Structure Definition

Capital Structure Definition –  Capital structure of a company refers to the composition of debt and equity in a company. In involves all the long term finances such as loans, shares, etc.

For managing and survival of company, finances are very necessary. From the promotional stage to the end, it plays an important role in the life of the company. If funds are inadequate, the business suffers.  Therefore it is necessary that company correctly estimate the future capital needs for getting optimum capital structure.

The capital structure comprises of debt and equity securities refers to permanent financing of a firm. It further consists of long-term debt, preference share capital and shareholder’s funds.

Forms of Capital Structure

  • Only Equity
  • Equity and Preference shares composition
  • Composition of equity shares and debentures
  • Equity, preference and Debentures.

Factors Determining the Capital Structure

In order to understand capital structure definition in in-depth, let’s discuss the factors that determines the capital structure of a firm.

1. Financial Leverage

The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage. The use of long term debt magnifies the earning per share if the firm yields a return higher than the cost of debt. The earning per share also increases with use of preference share capital. However, while calculating taxes, there is reduction of interest income from the amount.

2. Growth and Stability of Sales

Growth and stability in sales highly influence the capital structure of the company. If the sales are expected to remain fairly stable, it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payment and repayments of debts. If sales are highly fluctuating, it should not employ debt financing in its capitals structure.

3. Cost of Capital

Cost of capital refers to the minimum rate of return expected by its suppliers. The capital structure should also provide for the minimum cost of capital. Usually, debt is cheaper source of finance compared to preference and equity. Preference capital is cheaper then equity because of lesser risk involved.

4. Cash flow Ability to Service the Debt

A firm which shall be able to generate larger and stable cash inflows can employ more debt in its capital structure as compared to the one
which has unstable and lesser ability to generate cash inflows. Whenever a firm wants to raise additional funds, it should estimate, project its cash inflows to ensure the coverage of fixed charges.

5. Nature and Size of Firm

Nature and size of firm also influences the capital structure. A public utility concern has different capital structure as compared to manufacturing concern. Public utility concern may employ more of debt because of stability and regularity of their earnings. Small companies have to depend upon owned capital, as it is very difficult for them to raise ling term loans on reasonable terms.

6. Control

Whenever additional funds are required, the management of the firm wants to raise the funds without any loss of control over the firm. In case funds are raised through the issue of equity shares, the control of existing shares are diluted. Preference shareholders and debenture holders de not have the voting right. From the point of view of control, debt financing is recommended.

7. Flexibility

Capital structure of the firm should be flexible. It should adjust itself with the changing condition. A firm should arrange its capital structure in such a way that it can substitute one form of financing by other. Redeemable preference share capital and convertible debentures may be preferred on account of flexibility.

8. Requirement of Investors

It is necessary to meet the requirement of both institutional as well as private investors in case of debt financing. Investors who are over cautious prefer safety of investment, so debentures would satisfy such investors. Investors, who are less cautious in approach, will prefer preference share capital.

9. Capital Market Conditions

Market conditions also influence the choice of securities. If share market is going down the company should not issue equity share capital of debt as investors would prefer safety. In case of boom period, it would be advisable to issue equity share capital.

10. Assets structure

If fixed assets constitute a major portion of the total assets of the company, it may be possible for the company to raise more of long term debts.

11. Period of Financial

If there is requirement of finances for shorter period, issuing debenture is best. If company requires funds for longer period, then issuing equity share is more appropriate.

12. Purpose of financing

If funds are required for the productive purpose, debt financing is suitable as interest can be paid out of profits generated from the investment.

13. Costs of flotation

The cost of financing a debt is generally less than the cost of floating equity and hence it may persuade the management to raise debt financing.

14. Personal Consideration

Management, which is experienced and very enterprising, does not hesitate to use more of debts in their financing as compared to less experienced and conservative management.

15. Corporate Tax Rule

High rate of corporate taxes on profits compels the companies’ to prefer debt financing. Because interest is deductible while calculating taxes.

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