DETERMINANTS OF CAPITAL STRUCTURE

Ø  MEANING OF CAPITAL STRUCTURE AND DETERMINANTS OF CAPITAL STRUCTURE
FINANCIAL MANAGEMENT

Ø  MEANING OF CAPITAL STRUCTURE

1.       CAPITAL STRUCTURE IS MADE UP OF DEBT,EQUITY,SECURITIES AND REFERS TO THE PERMANENT FINANCING OF A FIRM. IT IS COMPOSED OF LONG TERM DEBT,PREFERENCE SHARE CAPITAL AND SHAREHOLDER’S FUNDS.

2.       JAMES C VAN HORNE,” THE MIX OF FIRM’S PERMANENT LONG TERM FINANCING REPRESENTED BY DEBT,PREFERRED STOCK AND COMMON STOCK EQUITY.

3.       GRESTENBERG,” CAPITAL STRUCTURE OF A COMPANY REFERS TO THE COMPOSITION OR MAKE UP OF ITS CAPITALIZATION, AND IT INCLUDES ALL LONG TERM CAPITAL RESOURCES VIZ LOAN,RESERVE ,SHARES AND BONDS.

  MEANING

A.      CAPITALIZATION REFERS TO THE TOTAL AMOUNT OF SECURITIES ISSUED BY A COMPANY.

B.       CAPITAL STRUCTURE REFERS TO THE KIND OF SECURITIES AND THE PROPORTIONATE AMOUNTS THAT MAKE UP CAPITALIZATION

C.       CAPITAL STRUCTURE IS THE PROPORTION OF DEBT AND PREFERENCE  AND EQUITY SHARE ON BALANCE SHEET.

D.       FINANCIAL STRUCTURE MEANS THE ENTIRE LIABILITY SIDE OF BALANCE SHEET.

  CAPITAL STRUCTURE

  PATTERNS OF CAPITAL STRUCTURE

A.      EQUITY SHARES ONLY OR

B.       EQUITY AND PREFERENCE SHARE CAPITAL ONLY OR

C.       EQUITY SHARES CAPITAL AND DEBENTURES OR

D.       EQUITY SHARES,PREFERENCE SHARES AND DEBENTURES OR

  OPTIMAL CAPITAL STRUCTURE

·  CAPITAL STRUCTURE AT WHICH THE WEIGHTED AVERAGE COST OF CAPITAL IS MINIMUM AND THEREBY MAXIMUM VALUE OF THE FIRM.

·  OPTIMAL CAPITAL STRUCTURE IS THAT CAPITAL STRUCTURE OR COMBINATION OF EQUITY AND DEBTS LEADS TO THE MAXIMUM VALUE OF THE FIRM.

·  OPTIMAL CAPITAL STRUCTURE MAXIMIZES THE VALUE OF COMPANY AND HENCE THE WEALTH OF SHAREHOLDERS AND MINIMIZES THE COMPANY’S COST OF CAPITAL.

·  FOLLOWING CONSIDERATION SHOULD BE KEPT IN MIND WHILE DESIGNING THE OPTIMAL CAPITAL STRUCTURE.

1.       COMPARE THE RETURN ON INVESTMENT WITH FIXED COST FUNDS: IF THE RETURN IS HIGHER THAN FIXED COST FUND THE ORGANIZATION SHOULD MAKE MAXIMUM POSSIBLE USE OF LEVERAGE.

2.       USE OF DEBT SAVES TAX LIABILITY.

3.       AVOID UNDUE FINANCIAL RISK

4.       FLEXIBLE

·  RISK AND RETURN TRADE OFF

1. FINANCIAL RISK:- ARISES ON THE USE OF DEBT OR FIXED INTEREST BEARING SECURITIES IN THE CAPITAL. A FIRM USING DEBT IN THE CAPITAL STRUCTURE HAS TO FIXED INTEREST INCREASES THE RISK OF LIQUIDATION. IT ALSO IMPLIES THE VARIABILITY OF EARNINGS AVAILABLE TO EQUITY SHAREHOLDERS.
2. NON EMPLOYMENT OF DEBT CAPITAL RISK:-IF THE FIRM DOES NOT USE DEBT IN THE CAPITAL STRUCTURE IT HAS TO FACE THE RISK ARISING OUT OF NON EMPLOYMENT DEBT FUNDS. NEED RISK HAS AN INVERSE RELATIONSHIP WITH THE RATIO OF DEBT IN ITS TOTAL CAPITAL

·         THE FIRM HAS TO BALANCE BETWEEN FINANCIAL RISK AND RISK OF NON EMPOYMENT OF DEBT.

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·  CAPITAL STRUCTURE DECISIONS

·  CAPITAL STRUCTURE IS VERY IMPORTANT TO SURVIVE THE BUSINESS IN THE LONG RUN. CAPITAL STRUCTURE DECISION REFERS TO THE DESIGNING OF AN APPROPRIATE CAPITAL STRUCTURE. PLANNING THE CAPITAL STRUCTURE MEANS SELECTING A DESIRED DEBT AND EQUITY COMBINATION.

·  FACTORS /DETERMINANTSDETERMINING THE CAPITAL STRUCTURE

1. FINANCIAL LEVERAGE : THE USE OF LONG TERM FIXED INTEREST BEARING DEBT AND PREFERENCE SHARE CAPITAL IS CALLED FINANCIAL LEVERAGE OR TRADING ON EQUITY.THE USE OF LONG TERM DEBT AND PREFERENCE INCREASES THE EPS IF THE FIRM YIELDS A RETURN HIGHER THAN COST OF DEBT.HOWEVER LEVERAGE CAN OPERATE ADVERSELY ALSO IF THE RATE OF INTEREST ON LONG TERM LOAN IS MORE THAN EXPECTED EARNING.
2. COST OF CAPITAL :EVERY RUPEE INVESTED IN A FIRM HAS A COST. COST OF CAPITAL REFERS TO MINIMUM RETURN EXPECTED BY ITS SUPPLIERS. WHILE FORMULATING A CAPITAL STRUCTURE AN EFFORT MUST BE MADE TO MINIMIZE THE OVER ALL COST OF CAPITAL.THE MAIN SOURCE OF  FINANCE FOR A FIRM ARE EQUITY,PREFERENCE AND EQUITY SHARE CAPITAL. DEBT IS CHEAPER AS COMPARED TO EQUITY AND PREFERNCE BECAUSE OF TAX ADVANTAGE DUE TO DEDUCT ABILITY OF INTEREST.PREFERENCE SHARE CAPITAL IS ALSO CHEAPER THAN EQUITY BECAUSE OF LESS RISK AND  FIXED RATE OF DIVIDEND.

3. RISK :
1. BUSINESS RISK :-REFERS TO VARIABILITY OF EARNINGS BEFORE INTEREST AND TAXES. IT MAY BE INTERNAL AS WELL EXTERNAL. INTERNAL RISK IS ASSOCIATED WITH EFFICIENCY WITH WHICH IT MANAGES THE OPERATIONS. EXTERNAL RISK DUE TO CHANGES IN THE ENVIRONMENT.
2. FINANCIAL RISK :- MAY NOT BE ABLE TO COVER ITS FIXED FINANCIAL COSTS. IT IS ASSOCIATED WITH THE CAPITAL STRUCTURE OF A COMPANY. WHEN A FIRM USES MORE DEBT,IT INCREASES THE FINANCIAL RISK.

4. GROWTH AND STABILITY OF SALES:- IF THE SALES ARE STABLE  AND GROWING THE FIRM CAN USE MORE DEBT AS IT IS IN POSITION TO MAKE PAYMENT OF DEBT. BUT IF SALES ARE UNSTABLE.IT SHOULD USE LESS DEBT.
5. CASH FLOW ABILITY TO SERVICE DEBT:- DEBT FINANCING IMPLIES BURDEN OF FIXED CHARGE DUE TO  THE FIXED PAYMENT OF INTEREST AND PRINCIPLE. IF THE FIRM HAS SUFFICIENT CASH FLOW CAN USE MORE DEBT AS COMPARED TO THE FIRM HAVING LOW CASH FLOW ABILITY. FIXED CHARGES AND INTEREST COVERAGE RATIO CAN BE CALCULATED. INTEREST COVERAGE RATIO=EBIT/FIXED INTEREST CHARGE
6. NATURE AND SIZE OF THE FIRM:-PUBLIC UTILITY FIRMS MAY EMPLOY MORE OF DEBT BECAUSE OF STABILITY AND REGULARITY OF EARNINGS. SMALL COMPANIES HAVE TO DEPEND ON THEIR OWN CAPITAL. THE ORGANIZATIONS  WHICH CAN NOT PROVIDE STABLE EARNING  USE LESS DEBTS.

7. CONTROL:-FROM THE POINT OF VIEW OF CONTROL,DEBT FINANCING IS RECOMMENDED. BECAUSE IN CASE OF REQUIREMENTS IF THE ADDITIONAL FUNDS ARE RAISED THROUGH THE ISSUE OF EQUITY SHARES THE CONTROL OF THE EXISTING SHARES WILL BE DILUTED. SO THEY MAY RAISE THE FUNDS BY WAY OF FIXED INTEREST EARNING DEBTS AND PREFERENCE SHARE CAPITAL
8. FLEXIBILITY:- CAPITAL STRUCTURES SHOULD BE FLEXIBLE MEANS ADJUSTED ACCORDING TO THE NEEDS OF THE CHANGING CONDITIONS.
9. REQUIREMENT OF INVESTORS:-INVESTORS ARE GENERALLY CLASSIFIED INTO THREE CATEGORIES:-
1. BOLD INVESTOR: WILLING TO TAKE RISK
2. CAUTIOUS INVESTOR:- SAFETY OF INVESTMENT AND STABILITY OF RETURN.DEBENTURE WOULD SATISFY
3. LESS CAUTIOUS:-PREFER PREFERENCE SHARES WHICH PROVIDE STABILITY IN THEIR REQUIREMENT
   
   
10. CAPITAL MARKET CONDITIONS:-IF THE SHARE MARKETS ARE DEPRESSED THEN THERE ARE PESSIMISTIC BUSINESS CONDITIONS,THE COMPANY SHOULD NOT ISSUE EQUITY SHARES BUT IF THE OPTIMISTIC CONDITIONS EXIST THEN COMPANY SHOULD GO FOR EQUITY.
11. ASSET STRUCTURE:-THE LIQUIDITY AND THE COMPOSITION OF ASSETS SHOULD BE KEPT IN MIND WHILE SELECTING THE CAPITAL STRUCTURE. IF FIXED ASSETS CONSTITUTE A MAJOR PORTION OF THE TOTAL ASSETS OF THE COMPANY.THE COMPANY CAN RAISE MORE DEBTS.
12. PURPOSE OF THE FINANCING :-IN CASE OF PRODUCTIVE PURPOSE THE USE OF DEBTS CAN BE MADE BUT IF THE FUNDS ARE REQUIRED FOR UNPRODUCTIVE PURPOSE THEN EQUITY
13. PERIOD OF FINANCE:-IF THE FINANCE IS REQUIRED FOR LIMITED PERIOD DEBENTURES SHOULD BE PREFERRED BUT IF IT IS REQUIRED FOR LONGER DURATION THEN EQUITY
14. PERSONAL PREFERENCE
15. HIGH CORPORATE TAX ALSO FORCE COMPANIES TO PREFER DEBT FINANCING

7. LEGAL REQUIREMENTS:- DEBT EQUITY RATIO DOES NOT EXCEED 2:1 /THE RATIO OF PREFERENCE CAPITAL TO EQUITY DOES NOT EXCEED 1:3 OR PROMOTER SHOULD HOLD AT LEAST SO MUCH OF EQUITY CAPITAL.