Question

What are the factors affecting Capital structure???

Answer 1

Hi AditiBeautifull,
Here's your answer..

Aadhar what's up capital structure means a composition on makeup of the amount of long term funds . According to C.W Gerstenberg ," Capital structure means the type of securities to be issued and the propertionate amounts that make up the capitalisation" . Long term funds can b long term funds can be obtained from -
a) owners
b) borrowers.
Ownership funds concepts of share capital, and retained earnings. Borrowed funds include debentures, and long term loans. The ratio between equity (owned funds) and debt ( borrowed funds) is called capital gearing trading on thin equity. On the other hand, when is equity demonates the capital structure, it is known as low gearing or trading on thick equity .

That factors of it are-


1) trading on equity.

2) needs of inventors

3) cash flow position

4) period and purpose of financing

5) cost of Financing

6) need for flexibility

7) capital market conditions

8) exercise of control

9) Statutory Requirements

10) Nature of business.

Hope it helps..

Answer 2

The Factors affecting Capital Structure are as follows:-


1. Trading on Equity (Financial Leverage) :- When a company uses borrowed funds in the regular conduct of business along with equity capital it is said to be trading on equity. When the rate of earnings of a company is higher than the rate of interest at which funds are borrowed, equity shareholders can get higher earning per share due to two reasons. First, the rate of return on investment is more than the rate of interest and dividend payable on debit and preference capital respectively. Secondly, interest paid on debit is deducted from profits while calculating tax. Suppose, a company raises Rs 1 crore. First, alternative is Rs 30 Lakhs Debentures, Rs 10 Lakhs from Preference Shares and Rs 60 Lakhs from Equity Share. Second alternative is Rs 10 Lakhs from Debentures, Rs 90 Lakhs from Equity Shares. The amount of earning is Rs 20 Lakhs for both the companies. The rate of interest on debentures is 12% and the rate of of dividend on preference shares in 14%, then the earning per share for equity shareholders will be as follows:
Financial leverage has two main implications. First use of fixed charge securities will increase return to equity shareholders only if rate of fixed charge is lower than the returns on investment. Second, use of fixed charge securities involves risk and treat of insolvency because debt has to be repaid along with interest even when the company is in loss. The financial leverage employed by a company will depend on the degree of risk the company is willing to take. Trading on equity is, however, desirable only when :-

(a) The Rate of earnings is higher than the rate of interest and the rate of preference dividend.

(b) The company's earnings are stable and regular to pay at least the interest on debentures.

(c) There are sufficient fixed assets to offer as security to the lenders.When the proportion of debt and equity is such that it results in increase in shareholders' wealth, the capital structure may be called optimum.


2. Exercise of Control :- In a company, equity shareholders have voting right and therefore, control of the company lies in their hands. If the promoters of the company want to retain control in their own hands, they may not issue additional equity shares to the public. In such case, more funds can be raised by issuing Debentures and Preference shares. This factor is particularly important in closely held companies whenever promoters have a low share holding.


3. Need for Flexibility :- A good capital structure should be flexible so that adjustments can be made whenever the need arises. Debentures and preference shares can be paid off whenever the company feels necessary. But equity shares cannot be paid off during the lifetime of a company. However, Debentures and Preference Shares are generally not issued in initial stages because they involved a fixed burden of payments on company's earnings. While raising debt,the company should ensure that there are minimum restrictions in loan agreements.


4. Nature of Business :- Companies enjoying regular and liberal earnings, e.g. public utilities can afford to have high capital gearing. On the other hand, business firms which are subject to wide fluctuations in demand and earning may find it safer to depend more on equity capital and preference shares. New and stagnant firms may find it more difficult to issue Debentures and Preference shares than well-established and growing companies. The company should be able to generate enough cash inflows to meet its fixed commitments on debt. A projected cash flow statement can be prepared to judge future cash flows or liquidity position of the company.


 5. Cost of Financing :- In a good financial structure, the cost of capital should be reasonably low. Cost of capital depends upon prevailing rate of interest, return expected by potential investors, expenses and administrative expenses. Issue of expenses or floatation costs of shares are high. Normally, the cost of debt is lower than that of equity. A company should estimate and compare the cost of alternative sources of finance before making a choice among them. A high rate of tax debt financing more attractive. In addition to cost, several legal formalities are involved in the issue of shares and debentures.


6. Period and Purpose of Financing :- For funds required for permanent investment equity shares are the appropriate choice. Debentures and preference shares are preferable for medium-term finance. Modernization and expansion programmes may better be financed through preference shares and debentures. Finance needed for  expansion of capacity may be raised through fixed charge securities as expansion is likely to increase the earning capacity of the company.



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