Capital Structure

The financial requirement of a firm can be met through ownership capital or borrowed capital. The ownership capital refers to the amount of capital contributed by the owners. In case of a company, it refers to the amount of funds raised by issuing shares. The main characteristic of the ownership capital is that its contributors are entitled to get dividend out of earnings after the payment of interest and taxes. Hence, the rate of return on such capital depends upon the level of profits earned, and, if there are no profits, no dividend may be paid.

Borrowed capital refers to the amount of funds raised through long term loans and debentures on which its contributors are entitled to a fixed rate of interest which has to be paid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also a commitment that the principal amount shall be repaid on maturity. However, it is still considered advantageous to finance business activities through borrowed capital because if the rate of earnings from the planned business investment is expected to be better than the rate of interest on the borrowed funds, it shall ensure higher returns on owners’ funds.

Example

Suppose the total investment in a business is Rs. 50 lakh, to which owners contribute Rs.20 lakh and the remaining amount of Rs.30 lakh is funded through loans at 10% interest per annum. Assuming expected annual earnings before interest and tax are Rs. 10 lakh (20% on total investment) the profit after payment of interest but before tax will be Rs.7 lakh (Rs.10 lakh - Rs.3 lakh). Assume that the tax is payable on profits at the rate of 40%, the profit after tax will be Rs.4.20 lakh (Rs.7 lakh - Rs.2.80 lakh tax) and the return on owners’ funds will be 21%.

Now, suppose the whole amount of required investment of Rs.50 lakh is contributed by the owners and no loan is taken. Since no interest is payable, the amount of tax will be Rs.4 lakh (40% on Rs.10 lakh) and the profit after tax Rs.6 lakh (Rs.10 lakh - Rs.4 lakh tax). This shall result in 12% return on owner’s funds.

Thus, owners get higher return when a part of capital required is funded by borrowings. This is called Trading on Equity or Leverage Effect. But, there is also an element of risk in using borrowed funds because when the profits decline, interest being a fixed charge, the return on owners’ funds is likely to decline. This implies that dependence on borrowings should be kept within reasonable limits. Therefore, most companies generally plan to raise the required amount of long-term funds by using a judicious mix of ownership capital (called equity) and borrowed capital (called debt).

The mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure. Thus, the term capital structure refers to the make up of a firm’s capital in terms of the planned mix of different kinds of long-term funds like equity shares, preference shares, debentures and long term funds. So capital structure involves two basic decisions:

1. The type of securities to be issued or raised
2. The relative proportion of each type of security

Factors Determining Capital Structure

The mix of debt and equity used (called the capital structure) for meeting the capital requirements of a company affects the rate of return on owners' capital (shareholders’ funds). This in turn, determines the earnings per equity share (EPS) and has its effect on the market value of company’s shares. Hence, the choice of an appropriate capital structure becomes a very important decision for the finance manager of any company.

He should make this decision on the basis of reliable data and after careful analysis of all the factors that influence this choice. Following are the factors that should be kept in view while deciding on the choice of an appropriate capital structure.

1. Expected earnings and their stability

If the expected earnings, in terms of rate of return on the amount to be invested are sufficiently large, use of debt is considered quite desirable. Not only that, the stability of earnings should also be taken into account because if the firm is engaged is business activities in which sales and profits are subject to wide fluctuations, it will be risky to use higher proportion of debt.

In other words, if there is an element of uncertainty about the expected earnings it is considered better to rely more on equity share capital. However, with assured prospects of rising earnings, there should be greater reliance on debt so as to take advantage of leverage effect.

2. Cost of debt

If the rate of interest on borrowings is lower than the expected rate of return on capital employed, then debt may be preferred. With lower cost of debt financing, the overall cost of financing is reduced and the return on equity capital will be higher.

3. Right to manage the business

The debenture holders and preference shareholders do not have much say in management of the company. This authority lies primarily with the equity shareholders who have the voting rights.

Hence, while deciding on the mix of equity and debt, the promoters or existing management of the company may also take into account the possible effect of raising funds through equity shares on the right to control the business. In order to retain their right to control the affairs of the company, they may prefer to raise additional funds mainly through debentures and preference shares.

4. Capital market conditions

The conditions in the capital market also influence the capital structure decision. At times capital market is so depressed that the investors are unwilling to subscribe to shares. In such a situation, it is considered better to rely on debt or defer the decision till a favourable market condition is restored.

5. Regulatory norms

While deciding on the capital structure, the legal constraints like the limit on debt-equity ratio should also be kept in view. At present, such limit is 2:1 in most cases. This implies that at any point of time, the debt should not be more than twice the amount of share capital. This limit keeps on changing with changing economic environment and varies from industry to industry.

6. Flexibility

The planned capital structure should be flexible enough to raise additional funds without much difficulty. The company should be able to raise additional capital in the form of debt or equity whenever required. But if the company’s capital structure has too much debt, then the lenders may not be able to give more loan to the company.

In a such a situation it may be forced to raise the funds only through shares for which the capital market condition may not be conducive. Similarly, when on account of declining business and lack of other investment opportunities the funds need to be refunded, it may not be possible to do so if the company has heavily relied on equity shares which cannot be redeemed easily.

Hence, to ensure an element of flexibility, it is better if the firm relies more on redeemable securities that can be paid off if necessary and, at the same time, have some unused debt raising capacity so that future financial needs can be fully taken care of without much difficulty.

7. Investors’ attitude towards investment

While planning the capital structure of a company one must bear in mind that all investors do not have the same attitude towards their investment. Some are highly conservative who prefer safety  to return. For such investors, debentures are considered most suitable.

As against this, there are some who are interested in high return on their investments and are ready to take the risk involved. Such investors prefer equity shares. Then, there are many who are willing to take a limited risk provided the return is better than the rate on secured debentures and bonds. Preference shares are most suitable for this category of investors.

In order to attract all categories of investors, it is considered more desirable to issue different types of securities specially when the amount of capital requirement is large.

Conclusion

An appropriate capital structure is one which:

1. Ensures maximum return on equity by making use of the leverage effect within reasonable limits of the risk involved
2. Caters to all types of investors by using a judicious mix of different types of securities
3. Has the necessary flexibility to make required reduction or addition to funds, according to changed conditions
4. Involves minimum risk of dilution in control of the company affairs by the existing group of shareholders
5. Fully keeps in view the legal constraints and the prevailing capital market conditions

The most judicious capital structure is one that minimises the cost of funds and maximises the shareholders wealth. In financial management terminology, such a capital structure is called optimal capital structure.