Capital Structure of a Company

Capital structure is one of the aspects which plays a vital role in business development. In this,
the equity and debt funds proportional arrangement are strategically made to raise capital for
future operations. Proper adaption of capital structure is necessary for business. However,
several factors should be considered and tracked before adapting a capital structure. These
factors differ by the types of business forms.

Capital structure decisions involve determining the types of securities to be issued as well as
their relative share in the capital structure. The financial decision regarding the composition of
the capital structure is made after the financial requirements have been established. It entails
determining how much money should be raised from each source of funding. In short, capital
structure decisions involve determining the type of securities to be issued and their relative
capital share.

Capital Structure refers to the proportion of debt and equity used for financial business
operations.

1. Cash Flow Position:

The composition of the capital structure is determined by the business’s ability to create cash
flow. It is essential to consider the cash flow in the future to choose the capital structure. The
company must have sufficient funds for funding business operations, investing in fixed assets,
and fulfilling debt obligations, such as interest and capital repayments. The firm must pay
dividends to preferred shareholders, fixed-rate interest to debenture holders, and loan principal
and interest. Sometimes, a company produces sufficient profit but is unable to produce cash
inflow for payments. If the company does not make its financial commitments, it may become
insolvent. Therefore, the expected cash flow must match the obligation to make payments.

If a company is confident in its ability to generate sufficient cash flow, it should use more debt
securities in its capital structure; however, if there is a cash shortage, it should use more equity
securities since there is no obligation to pay its equity owners.

2. Interest coverage ratio(ICR):

ICR signifies the number of times a company’s earnings before interest taxes (EBIT) meet its
interest payment. The ICR specifies the number of times EBIT can repay the interest obligation.
A high ICR shows that companies can have borrowed funds due to the lower risk of making
interest payments whereas a lower ratio shows that the company should use less debt.

3. Return on Investment(ROI):

Return on Investment is a crucial factor in designing an appropriate capital structure.

In case ROI> Rate of interest, then the company must prefer borrowed funds in capital structure
whereas in case ROI <Rate of interest on debt, then the company must avoid debt and use
equity financing.

4. Debt Service Coverage Ratio(DSCR):

Under this, the amount of money needed to pay off debt and the capital for preferred shares is
compared to the profit generated by operations.

A higher DSCR indicates a better capacity to meet cash obligations, which implies that the
company can choose more debt. However, in the case of lower DSCR, the company prefers
more equity.

5. Cost of debt:

The cost of debt has a direct impact on how much debt will be used in the capital structure. The
company will prefer higher debt over equity if it can arrange borrowed funds at a reasonable
rate of interest.

6. Tax Rate:

High tax rates reduce the cost of debt because interest paid to debt security holders is deducted
from income before calculating tax, whereas businesses must pay tax on dividends paid to
shareholders. So, a high tax rate implies a preference for debt, whereas a low tax rate implies
a preference for equity in the capital structure.

7. Cost of equity:

The cost of equity is another aspect that influences capital structure. The usage of debt capital
has an impact on the rate of return that shareholders expect from equity. The financial risk that
shareholders must deal with increases as more debt is used. The required rate of return rises
when the risk does as well. As a result, debt should only be used sparingly. Any use beyond the
amount increases the cost of equity, and even though the EPS is higher, the share price may
fall.
8. Floatation Costs:

It is the cost incurred on the issue of shares or debentures. It includes costs like advertisement,
underwriting, brokerage, stamp duty, listing charges, statutory fees, etc. Before making a
decision, it is important to carefully calculate the costs associated with raising money from
various sources. There are additional formalities and costs associated with issuing shares and
debentures. However, it is less expensive to raise funds through loans and advances.

9. Risk Consideration:

There are two categories of risk:

Financial risk is the state in which a business is unable to pay its set financial obligations, such
as interest, a dividend on preferred stock, payments to creditors, etc.

Business risk refers to the risk of the business’s inability to pay its fixed operating expenses,
such as rent, employees’ salaries, insurance premiums, etc.

Total risk refers to the sum of business and financial risk. Thus, if the company’s business risk
is low, it may suffer financial risk, implying that more borrowed capital can be utilized. But
when business risk is higher, debt should be used to lower financial risk.

10. Flexibility:

The firm’s ability to borrow more money may be limited by an excessive amount of debt. It
must maintain some borrowing capacity to be flexible and deal with uncertain events.

11. Control:

The company’s equity stockholders are regarded as its owners, and they have complete control
over it. The control of shareholders is not affected, however, by the issuance of debt. Debt
should be employed if the current shareholders desire to keep control. The company might opt
for equity shares if they don’t mind giving up control.

12. Regulatory Framework:

When choosing its capital structure, every company is required to follow the legal framework.
The SEBI guidelines must be followed when issuing shares and debentures. Loans from banks
and other financial institutions are likewise subject to several regulations. Companies may
prefer to give securities as a source of additional capital if SEBI regulations are straightforward,
or they may opt for more loans if monetary policies are more flexible.
13. Stock Market Conditions:

Market conditions can be divided into two categories: boom conditions and recession or
depression conditions. These conditions have an impact on the capital structure, particularly if
the company plans to raise further capital. Depending on the state of the market, investors
might be more cautious in their dealings. People are willing to take a risk and buy stock shares
even at greater prices during a boom period. Investors favour debt, which has a fixed rate of
return, but, in a recession or depression period.

14. Capital Structure of other Companies:

Some businesses design their capital structures in accordance with industry norms. However,
it must exercise proper care as blindly following industry standards can result in financial risk.
If a company cannot afford the high risk, it should not increase debt just because other
companies are doing so.

What are Dividends?

Companies reward their shareholders by paying out dividends. These payments can
be made in the form of cash, stocks, other assets, and more; they are also typically
based on the company's profits but could come from debt instruments. Depending
upon a given firm's dividend policy, these payouts may happen quarterly or annually
- all while being subject to taxes. Investing in stock with the potential for dividend
returns is an attractive way to build wealth over time!

The types of dividends a company pays out depending on the types of securities they
offer. Common types include ordinary (cash) dividends, stock/share, property, and
liquidating/special dividends.

What are the Different Types of Dividends?

If you want to know what are the types of dividend that businesses pay out, each with its
advantages and disadvantages, keep reading.

1. Cash dividends
These are the most common type of dividends, paid out in cash. A company pays out a certain
portion of its profits as dividends to shareholders. For example, An IT firm, XYZ, has made Rs
500 crores in profit for the year 2020. They decided to pay their shareholders 20% of that
amount as a dividend, which would be Rs 100 Crore INR (500 Cr x 0.20).

This would mean each shareholder would receive a certain dividend amount, depending on
how much stock they own.

The advantages and disadvantages of cash dividends depend on the company's financial
situation. On the one hand, shareholders can benefit from receiving a dividend payment in
the form of cash; on the other hand, companies have less money to reinvest in their
businesses, which can limit growth potential.

Cash dividends provide an immediate return but also mean less money for companies to
reinvest and grow.

2. Stock dividends
As the name suggests, stock dividends are paid out as additional shares instead of cash. For
example, XYZ IT firm decided to pay its shareholders 20% of its profits as a stock dividend.
This would mean each shareholder will receive an additional share for every five shares they
own.

The advantage of stock dividends is that they can increase a shareholder's potential returns
without them having to invest more money. Additionally, companies won't have to part with
their profits as they do with cash dividends.
On the downside, they also don't provide immediate benefits and tend to carry more risk than
cash dividends. The market value of the new shares could be lower or higher than when the
original investment was made.
3. Property dividends
These various forms of dividend are paid out as assets instead of cash or shares. This could
be anything from real estate to antiques and can even include intangible assets such as
patents or copyrights.

The advantage of property dividends is that they can diversify an investment portfolio and
may provide more tax benefits than other types of dividends. On the downside, there is
always a risk that the value of these types of assets may decline over time, limiting potential
returns.
For example, XYZ IT firm pays its shareholders 10% of its profits as property dividends. This
would mean each shareholder will receive an additional asset worth Rs 50 Lakhs INR (500
Cr x 0.10).
4. Scrip dividends
Scrip dividends are similar to stock dividends, but instead of receiving additional shares
directly from the company, shareholders receive a scrip or voucher that can be exchanged for
shares on the market.
The advantage of scrip dividends is that they can provide more flexibility to investors as it
allows them to decide when and how much of their dividend money should be used for
reinvestment. On the downside, there is always a risk that the value of these types of assets
may decline over time, limiting potential returns.

For example, XYZ IT firm decides to pay its shareholders 10% of its profits as a scrip dividend.
This would mean each shareholder will receive a scrip worth Rs 50 Lakhs INR (500 Cr x 0.10)
that can be exchanged for market shares later.

5. Liquidating dividends
Liquidating dividends are paid out to shareholders when a company is winding down its
operations, and there isn't enough money left to pay out other different types of dividends.

The advantage of liquidating dividends is that they can provide a return for shareholders
even if the business has failed. On the downside, it typically means that all remaining assets
will be sold off to pay the dividend, and the company will cease to exist.
For example, XYZ IT firm decides to pay its shareholders 50% of its remaining assets as a
liquidating dividend. This would mean each shareholder will receive an amount equivalent
to Rs 250 Lakhs INR (500 Cr x 0.50) from the sale of the company's assets.

Impact of Dividend on Share Prices

The impact of dividends on share prices depends on the types of dividends being paid out.
Cash dividends tend to have a positive effect on share prices as investors are immediately
rewarded for their investment. Stock dividends can also increase the value of shares, but it
depends on how well the company performs in the future and whether or not the new shares
will be worth more than originally purchased. Property and scrip dividends may also have an
impact depending on their market value at the time of payout. Liquidating dividends usually
lead to a decline in share prices as all remaining assets are sold off, leaving shareholders with
no prospect of further returns.

As a shareholder, knowing about different types of dividends payouts before investing in any
portfolio is recommended to know what to expect from your investments.