Capital structure: meaning and factors determining the capital structure of an organization

1.1 Meaning of Financial Management: Financial management is a managerial activity

concerned with planning and controlling the firm’s financial resources. In other words, it is
concerned with acquiring, financing, and managing assets to accomplish the overall goal of a
business enterprise (mainly to maximize the shareholder’s wealth).

In today’s world where positive cash flow is more important than book profit, Financial
Management can also be defined as planning for the future of a business enterprise to ensure a
positive cash flow. Some experts also refer to financial management as the science of money
management. It can be defined as:

“Financial Management comprises of forecasting, planning, organizing, directing, coordinating

and controlling of all activities relating to acquisition and application of the financial resources
of an undertaking in keeping with its financial objective.”

Another very elaborate definition given by Phillippatus is:

“Financial Management is concerned with the managerial decisions that result in the acquisition
and financing of short-term and long-term credits for the firm.”

There are two basic aspects of financial management viz., procurement of funds and effective use
of these funds to achieve business objectives.

(a) Procurement of funds: Since funds can be obtained from different sources therefore their
procurement is always considered a complex problem by business concerns. In a global
competitive scenario, it is not enough to depend on the available ways of raising finance, rather
resource mobilization has to be undertaken through innovative ways to discover financial products
which may meet the needs of investors. Businesses are constantly seeing new and creative sources
of funds that are helping modern businesses to grow faster. For example: trading in Carbon Credits
is turning out to be another source of funding.

Funds procured from different sources have different risk, cost, and control characteristics. The
cost of funds should be at the minimum level; for that, a proper balancing of risk and control factors
must be carried out. Another key consideration in choosing the source of new business finance is
to strike a balance between equity and debt to ensure the funding structure suits the business. Some
of the sources of funds for a business enterprise are:

a) Equity: The funds raised by the issue of equity shares are the best from the risk point of
view for the firm since there is no question of repayment of equity capital except when the
firm is under liquidation. From the cost point of view, however, equity capital is usually
the most expensive source of funds. This is because the dividend expectations of
shareholders are normally higher than the prevailing interest rate and also because
dividends are an appropriation of profit, not allowed as an expense under the Income Tax
Act. Also, the issue of new shares to the public may dilute the control of the existing
shareholders.
b) Debentures: Debentures as a source of funds are comparatively cheaper than shares
because of their tax advantage. The interest the company pays on a debenture is free of tax,
unlike a dividend payment which is made from taxed profits. However, even when times
are hard, interest on debenture loans must be paid whereas dividends need not be. However,
debentures entail a high degree of risk since they have to be repaid as per the terms of the
agreement. Also, the interest payment has to be made whether or not the company makes
profits.
c) Funding from banks: Commercial Banks play an important role in funding business
enterprises. Apart from supporting businesses in their routine activities (deposits,
payments, etc.), they play an important role in meeting the long-term and short-term needs
of a business enterprise.
d) International funding: Funding today is not limited to the domestic market. With
liberalization and globalization, a business enterprise has options to raise capital from
International markets also. Foreign Direct Investment (FDI) and Foreign Institutional
Investors (FII) are two major routes for raising funds from foreign sources besides ADRs
(American depository receipts) and GDRs (Global depository receipts). The mechanism of
procurement of funds has to be modified in light of the requirements of foreign investors.
e) Angel financing: Angel financing is a form of an equity-financing where an angel investor
is a wealthy individual who provides capital for a start-up or expansion, in exchange for
ownership/equity in the company. Angel investors have idle cash available and are looking
for a higher rate of return than what is given by traditional investments. Typically, angels,
 as they are known, will invest around 25 to 60 percent to help a company get started. This
source of finance sometimes is the last option for startups which doesn’t qualify for bank
funding and are too small for venture capital financing.

(b) Effective utilization of funds: The finance manager is also responsible for the effective
utilization of funds. He has to point out situations where the funds are being kept idle or where
proper use of funds is not being made. All the funds are procured at a certain cost and after entailing
a certain amount of risk. If these funds are not utilized in a manner that generates an income higher
than the cost of procuring them, there is no point in running the business. Hence, it is crucial to
employ the funds properly and profitably. Some of the aspects of funds utilization are:

a) Utilization for fixed assets: The funds are to be invested in a manner so that the company
can produce at its optimum level without endangering its financial solvency. For this, the
finance manager would be required to possess sound knowledge of techniques of capital
budgeting.
Capital budgeting (or investment appraisal) is the planning process used to determine
whether a firm's long-term investments such as new machinery, replacement machinery,
new plants, new products, and research development projects would provide the desired
return (profit).
b) Utilization of working capital: The finance manager must also keep in view the need for
adequate working capital and ensure that while the firms enjoy an optimum level of
working capital, they do not keep too many funds blocked in inventories, book debts, cash,
etc.

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1.2 Meaning of Capital Structure: Capital structure is the combination of capital from different
sources of finance. The capital of a company consists of equity shareholders’ funds, preference
share capital, and long-term external debts. The source and quantum of capital are decided keeping
in mind the following factors:

i. Control: Capital structure should be designed in such a manner that existing shareholders
continue to hold the majority stake.
 ii. Risk: Capital structure should be designed in such a manner that the financial risk of a
company does not increase beyond the tolerable limit.
iii. Cost: The overall cost of capital remains minimum.

Practically, it is difficult to achieve all of the above three goals together, hence, a finance manager
has to make a balance among these three objectives. However, the objective of a company is to
maximize the value of the company, and it is the prime objective while deciding the optimal capital
structure.

Capital Structure decision refers to deciding the forms of financing (which sources to be tapped);
their actual requirements (amount to be funded) and their relative proportions (mix) in total
capitalization.

Ko = [{Kd × D/ (D+S)} +
{Ke × S/(D+S)}]

Where:

• Ko is the weighted average cost of capital (WACC)

• Kd is the cost of debt
• D is the market value of debt
• S is the market value of equity
• Ke is the cost of equity

Capital structure decisions will decide the weight of debt and equity and ultimately the overall cost
of capital as well as the value of the firm. So, the capital structure is relevant in maximizing the
value of the firm and minimizing the overall cost of capital. Whenever funds are to be raised to
finance investments, a capital structure decision is involved. A demand for raising funds generates
a new capital structure since a decision has to be made as to the quantity and forms of financing.
The process of financing or capital structure decision is depicted in the figure below.
Financing Decision Process
1.3 Factors Determining Capital Structure:

A firm has the choice to raise funds for financing its investment proposals from different sources
in different proportions. It can:

a) Exclusively use debt (in case of an existing company);

b) Exclusively use equity capital, or
c) Exclusively use preference share capital (in case of an existing company), or
d) Use a combination of debt and equity in different proportions, or
e) Use a combination of debt, equity, and preference capital in different proportions, or
f) Use a combination of debt and preference capital in different proportions (in case of an
existing company).

The choice of the combination of these sources is called a capital structure mix. But the question
is which of the pattern should the firm choose? While choosing a suitable financing pattern, certain
fundamental factors should be kept in mind, to design capital structure, which has been discussed
below:

1. Financial leverage or trading on equity: The use of long-term fixed interest-bearing debt and
preference share capital along with equity share capital is called financial leverage or trading on
equity. The use of long-term debt increases the earnings per share if the firm yields a return higher
than the cost of debt. The earnings per share also increase with the use of preference share capital
but since interest is allowed to be deducted while computing tax, the leverage impact of debt is
much more. However, leverage can operate adversely also if the rate of interest on a long-term
loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the
capital structure of a firm.

2. Nature of the business: Capital Structure of a firm largely depends on the nature of the business
a firm undertakes. Firms that operate in monopoly or oligopoly markets generally have a stable
income and low business risk as compared to perfectly competitive firms. As a result, they may
employ a higher proportion of Debt Capital in their Capital Structure. On the other hand, perfectly
competitive firms face high risk and hence rely more on Equity Capital.

3. Size of the organization: Small-scale firms generally have lower capital requirements and hence
rely mostly on their own capital. Moreover, many times, financial institutions impose strict lending
conditions on such firms, as a result of which they are forced to avoid Debt Capital. On the other
hand, large firms get easy access to institutional credit and hence can depend on Debt Capital.
Moreover, they also have higher capital requirements which can hardly be met by new issues
always. For this reason, they also depend equally on Debt Capital.

4. Growth and stability of sales/income: The capital structure of a firm is highly influenced by the
growth and stability of its sales. If the sales of a firm are expected to remain fairly stable, it can
raise a higher level of debt. The stability of sales ensures that the firm will not face any difficulty
in meeting its fixed commitments of interest repayments of debt. Similarly, the rate of growth in
sales also affects the capital structure decision. Usually, greater the rate of growth of sales, greater
can be the use of debt in the financing of a firm. On the other hand, if the sales of a firm are highly
fluctuating or declining, it should not employ, as far as possible, debt financing in its capital
structure.

5. Control: While designing a capital structure, the finance manager may also keep in mind that
existing management control and ownership remain undisturbed. The issue of new equity will
dilute existing control patterns and it also involves higher costs. Issue of more debt causes no
dilution in control but causes a higher degree of financial risk.

6. Flexibility: By flexibility, it means that the management chooses such a combination of sources
of financing that it finds easier to adjust according to changes in need of funds in the future too.
While debt could be interchanged (If the company is loaded with a debt of 18% and funds are
available at 15%, it can return old debt with new debt, at a lesser interest rate), the same option
may not be available in case of equity investment. Thus, the capital structure of a firm should be
flexible which allows a firm the ease of changing the components of its Capital Structure as and
when needed.

7. Market sentiments/ capital market conditions: Capital market conditions do not remain uniform
throughout the year. As a result, while in a buoyant capital market, new issues are often
oversubscribed, at times of slump, companies hardly find buyers for the new shares. Hence, in
such a situation, there remains no other alternative than to resort to institutional financing in the
form of a loan. Thus, it can be said that capital market conditions do have a significant impact on
the Capital Structure a company plans.
8. Investors’ perception of the market: Capital Structure of a firm also depends on the attitude of
the investors in the capital market. In an economy where investors are mostly risk averse,
companies will find it difficult to issue securities in the market and should depend on institutional
loans to meet their requirement of funds. On the other hand, in economies with risk-taker investors,
new issues of shares, debentures, and other innovative products will be the most favored route.

9. Assets structure: Capital Structure decisions are closely associated with the structure of assets
of any firm. A firm should avoid financing Current Assets with long-term capital sources.
Moreover, a part of the fixed assets may be financed by long-term Debt Capital with matching
maturity.

10. Purpose of financing: Capital Structure also depends on the purpose of financing. To finance
normal operating activities, a firm may rely on Debt Capital or Preference Share Capital as the
fixed charges can easily be funded from the regular income. On the other hand, expansion projects
which will take time to materialize should preferably be financed by equity share capital or from
retained earnings.

11. Period of finance: This is another important factor determining the Capital Structure of a firm.
A firm should finance the projects with a fixed completion period through sources like Debt
Capital or Preference Share Capital (which are compulsorily redeemable) by properly aligning the
maturity profile of the instruments with the period of the projects. On the other hand, projects,
which do not have any fixed completion period, should preferably be financed by equity share
capital which is not associated with compulsory redemption.

12. Government policies: Many times, monetary and fiscal policy measures undertaken by the
government significantly affects the Capital Structure of a firm. When the government follows a
liberal policy and allows foreign institutional investors to participate in the capital market,
companies find it easier to raise required funds by issuing new shares. Similarly, domestic
companies, when allowed to raise finance from international capital markets, enjoy better options
to form a sound Capital Structure.

13. Statutory requirements: Market regulators of each country issue various regulations to be
abided by the issuers of securities. For example, in India, companies cannot issue irredeemable
preference shares or rights issues can be made only after a minimum gap from the initial public
offering. Similarly, banking companies are not allowed to issue securities other than equity shares.
Thus, a firm’s Capital Structure must be planned taking into consideration all the regulatory
requirements of the concerned country.

14. Cost of capital: According to this principle, an ideal pattern or capital structure minimizes the
cost of capital structure and maximizes earnings per share (EPS). E.g., Debt capital is cheaper than
equity capital from the point of its cost and interest being deductible for income tax purposes,
whereas no such deduction is allowed for dividends.

15. Risk consideration: While deciding about the capital structure of a firm, one needs to estimate
the two types of risks i.e. business risk and financial risk. Business risk arises due to changes in
demand, price, competition, and costs such as input costs and fixed costs. A firm with higher
business risk will borrow less because they do not have a stable earnings trend. Whereas, firms
with lower business risk may borrow more as their earnings are stable. There are fewer variations
in the earnings of such firms due to changes in price, demand, and competition. Financial risk is
the risk that arises due to financial leverage. It is the increased probability of insolvency or risk
that arises when the firm uses fixed cost (interest) bearing sources of funds like debentures, bonds,
and term loans. Higher use of debt increases the commitment of the firm concerning fixed charges
(interest) and repayment of the principal amount. Non-payment of these fixed charges may push
the company into liquidation. However, if a company uses equity capital, there is no such fixed
commitment. The dividend is payable only when there are enough profits and equity capital is not
refunded during the lifetime of the company. A capital structure is called an efficient capital
structure if the total risk of the firm is at a minimum level. The excessive use of debt should be
avoided to keep the financial risk of the company at a minimum level. Again, if a firm is having
higher business risk, then it should try to minimize its financial risk.

Thus, a finance manager in designing a suitable pattern of the capital structure must
bring about a satisfactory compromise between the above principles. The compromise can be
reached by assigning weights to these principles in terms of the various characteristics of the
company.
1.4 Optimal Capital Structure:

The objective of financial management is to maximize shareholder’s wealth. Therefore, one

should choose a capital structure that maximizes wealth. For this purpose, the following analysis
should be done:

1. EBIT-EPS-MPS analysis: Choose a capital structure that maximizes market price per share.
For that, start with the same EBIT for all capital structures and calculate EPS. Thereafter,
either multiply EPS by the price-earnings ratio (P/E ratio) or divide it by the cost of equity
to arrive at MPS.
2. Indifference Point analysis: In the above analysis, we have considered value at a given
EBIT only. What will happen if EBIT changes? Will it change your decision also? To
answer this question, you can do an indifference point analysis.
3. Financial Break-Even Point (BEP) analysis: With the change in capital structure, financial
risk also changes. Though this risk has already been considered in the P/E ratio or cost of
equity in point one above, one may calculate and consider it separately also by calculating
Financial BEP.