Capital Structure

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions-

1. Type of securities to be issued are equity shares, preference shares and long term borrowings( Debentures).
2. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into two-
1. Highly geared companies- Those companies whose proportion of equity capitalization is small.
2. Low geared companies- Those companies whose equity capital dominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be Rs. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Rs. 5 lakh, while in company B, ratio of equity capital is Rs. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

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.

Determining the Type of Capital Structure

The next step or the problem in calculating the weighted average cost is the selection of capital structure from which the weights are obtained.

There may be several possibilities

(a) Current capital structure either before or after the projected new financing

(b) Marginal capital structure, i.,e., proportion of various types of capital in total of additional funds to be raised at a certain time

(c) optimal capital structure. All may agree that firms do seek optimum capital structure, i.e., the capital structure that minimizes the average cost of capital.

Unless we have reasons to believe that the current structure deviates substantially from the optimum capital structure, we may assume that the current capital structure is the optional capital structure and use it in the assignment of weights. The marginal capital structures is irrelevant here.

Characteristics of a sound financial plan

The success of a business very much depends upon a financial plan (capital plan) based upon certain basic principles of corporation finance.

The essential characteristics of an ideal capital plan may briefly be summarised as follows:-

(1) Simplicity. The capital plan of a company should be as simple as possible. By 'simplicity' we mean that the plan should be easily understandable to all and it should be free from complications, and/or suspicion-arising statements. At the time of formulating capital structure of a company or issuing various securities to the public, it should be borne in mind that there would be no confusion in the mind of investors about their nature and profitability.

(2) Foresight. The planner should always keep in mind not only the needs of 'today' but also the needs of 'tomorrow' so that a sound capital structure (financial plan) may be formed. Capital requirements of a company can be estimated by the scope of operations and it must be planned in such a way that needs for capital may be predicted as accurately as possible. Although, it is difficult to predict the demand of the product yet it cannot b an excuse for the promoters to use foresight to the best advantage in building the capital structure of the company.

(3) Flexibility. The capital structure of a company must be flexible enough to meet the capital retirements of the company. The financial plan should be chalked out in such a way that both increase and decrease in capital may be feasible. The company may require additional capital for financing scheme of modernisation, automation, betterment of employees etc. It is not difficult to increase the capital. It may be done by issuing fresh shares or debentures to the public or raising loans from special financial institutions, but reduction of capital is really a ticklish problem and needs statesman like dexterity.

(4) Intensive use. Effective use of capital is as much necessary as its procurement. Every 'paisa' should be used properly for the prosperity of the enterprise. Wasteful use of capital is as bad as inadequate capital. There must be 'fair capitalisation' i.e., company must procure as much capital as requires nothing more and nothing less. Over-capitalisation and under capitalisation are both danger signals. Hence, there should neither be surplus nor deficit capital but procurement of adequate capital should be aimed at and every effort be made to make best use of it.

(5) Liquidity. Liquidity means that a reasonable amount of current assets must be kept in the form of liquid cash so that business operations may be carried on smoothly without any shock to therm due to shortage of funds. This cash ratio to current ratio to current assets depends upon a number of factors, e.g., the nature and size of the business, credit standing, goodwill and money market conditions etc.

(6) Economy. The cost of capital procurement should always be kept in mind while formulating the financial plan. It should be the minimum possible. Dividend or interests to be paid to share holder (ordinary and preference) should not be a burden to the company in any way. But the cost of capital is not the only criterion, other factors should also be given due importance.