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Factors Determining Capital Structure
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August 17, 2018
Categories: 5th Sem Financial Management Notes
Factors Determining Capital Structure
1. Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed funds
on reasonable basis. It refers to additional profits that equity shareholders earn
because of issuance of debentures and preference shares. 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, equity shareholders are
at advantage which means a company should go for a judicious blend of preference
shares, equity shares as well as debentures. Trading on equity becomes more
important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting
rights in a concern as compared to the preference shareholders and debenture
holders. Preference shareholders have reasonably less voting rights while debenture
holders have no voting rights. If the company’s management policies are such that
they want to retain their voting rights in their hands, the capital structure consists of
debenture holders and loans rather than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such
that there is both contractions as well as relaxation in plans. Debentures and loans
can be refunded back as the time requires. While equity capital cannot be refunded at
any point which provides rigidity to plans. Therefore, in order to make the capital
structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The company’s policy generally is to have different categories
of investors for securities. Therefore, a capital structure should give enough choice to
all kind of investors to invest. Bold and adventurous investors generally go for equity
shares and loans and debentures are generally raised keeping into mind conscious
investors.
5. Capital market condition- In the lifetime of the company, the market price of the
shares has got an important influence. During the depression period, the company’s
capital structure generally consists of debentures and loans. While in period of boons
and inflation, the company’s capital should consist of share capital generally equity
shares.
6. Period of financing- When company wants to raise finance for short period, it goes
for loans from banks and other institutions; while for long period it goes for issue of
shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of
cost when securities are raised. 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.
8. Stability of sales- An established business which has a growing market and high
sales turnover, the company is in position to meet fixed commitments. Interest on
debentures has to be paid regardless of profit. Therefore, when sales are high,
thereby the profits are high and company is in better position to meet such fixed
commitments like interest on debentures and dividends on preference shares. If
company is having unstable sales, then the company is not in position to meet fixed
obligations. So, equity capital proves to be safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists
of loans from banks and retained profits. While on the other hand, big companies
having goodwill, stability and an established profit can easily go for issuance of
shares and debentures as well as loans and borrowings from financial institutions.
The bigger the size, the wider is total capitalization.