ulscuss Lhe dlfferenL flnanclal facLors and economlc facLors affecLlng Lhe flnanclal

sLrucLure of a buslness
What are the d|fferent factors that a f|nance manager needs to cons|der wh||e
tak|ngdec|s|ons regard|ng h|s]her f|rm's cap|ta| structure Lxp|a|n each of
these factors |n deta||


Cap|ta| structure of a company refers Lo Lhe composlLlon of long
Lerm sources of funds suchasordlnary shares preference shares debenLures bonds long
Lerm debLs eLc ln
oLherwords lL refers Lo Lhe klnd and proporLlon of securlLles for ralslng longLerm funds
lL lmplles LhedeLermlnaLlon of form or make
up of a companys caplLallsaLlon Some auLhors use
caplLallsaLlon and caplLal sLrucLure lnLerchangeably Powever caplLallsaLlon merely refers Lo
Lhe deLermlnaLlon of Lhe amounL of caplLal needed for successful buslness operaLlons whereas
caplLal sLrucLure ls concerned wlLh Lhe deLermlnaLlon of proporLlon of dlfferenL sources of
long
Lerm fundsln Lhe caplLallsaLlon of a company lL ls Lherefore evldenL LhaL `caplLallsaLlon an
d `caplLal sLrucLure are Lhe Lwo dlfferenL aspecLs of flnanclal plannlng

1he followlng facLors govern Lhe caplLal sLrucLure of a company
(1) 1rad|ng on Lqu|ty A Company earns Lhe proflLs on lLs LoLal caplLal (borrowed
and owned) Cn Lhe borrowed caplLal (lncludlng preference caplLal) company pays lnLere
sLor dlvldend aL a flxed raLe lf Lhls flxed raLe ls lower Lhan Lhe general raLe of earnlngs of Lhe
company Lhe ordlnary shareholders wlll have an advanLage ln Lhe form of addlLlonal proflLs
1hls may be referred Lo as Lradlng on equlLy 1hls `Lradlng on equlLy ls
an arrangemenL under whlch a
company makes use of borrowed funds lncludlng preference caplLal bearlng a flxed raLe oflnLe
resL or dlvldend ln such a way as Lo lncrease
Lhe raLe of reLurn on equlLy shares 1he raLe ofdlvldend on equlLy shares could noL oLher
wlse go beyond Lhe general raLe of earnlng lf wholeof lLs caplLal ls ralsed by Lhe lssue of
equlLy shares shares bearlng a raLe of lnLeresL/dlvldendbelow Lhe general raLe of reLurn
Company wlll also have an advanLage ln Lhe savlng of lncome Lax as lnLeresL pald on debenLures
ls a deducLlble expense 1hls double advanLage LempLs Lhe managemenL Lo Lrade on equlLy
(2) Des|re to Contro| the 8us|ness CulLe ofLen Lhe promoLers wanL Lo reLaln LheconLr
ol of Lhe affalrs of Lhe company 1hey ralse Lhe caplLal from Lhe publlc by lssulng dlfferenL
Lypes of securlLles ls such a way as Lo reLaln Lhe conLrol of whole or subsLanLlally
Lhe whole of Lheaffalrs of Lhe company wlLh Lhem lor Lhls purpose Lhey ralse a large proporL
lon of funds by Lhe lssue of debenLures and preference shares uebenLureholders
and preference shareholders areusually noL glven any voLlng rlghL as en[oyed by Lhe equlLy
shareholders A ma[orlLy of equlLy share caplLal ls Lherefore held by Lhe promoLers an
d Lhelr nearrelaLlves as only LheequlLy shareholders en[oy Lhe voLlng rlghL
ln Lhe conducL of Lhe affalrs of Lhe company 1hus Lhecompany collecLs lLs requlremenL of fun
ds from Lhe publlc Lhough Lhe conLrol resLs wlLh LhepromoLers
(3) Nature of 8us|ness naLure of buslness musL be Laken lnLo accounL whlle deslgnlng
Lheflnanclal plan and n have a deLermlnlng Lhe caplLal sLrucLure A manufacLurlng compa
ny maysLrucLure from merchanLlslng flnanclng exLracLlve or publlc uLlllLy concerns 1hese
enLerprlses dlffer ln regard Lo Lhe amounL of lnvesLmenL rlsk of fallures lnvolved Lrade cycles
and freedom from compeLlLlon 1hese dlfferences enable one Lype of buslness lssue securlLles
whlch are noL proflLable Lo oLher buslness So publlc uLlllLy
concern may en[oy advanLages of flxed lnLeresL securlLles llke bonds and debenLure becau
se of Lhelr monopoly and sLablllLy of lncome 8uL onLhe oLher hand manufacLurlng
concerns do noL en[oy such advanLages and rely Lo a greaL exLenL onequlLy share cap
(4) urpose of I|nanc|ng 1he purpose for
whlch funds are belng ralsed musL be Laken lnLoaccounL aL Lhe Llme of devlslng flnanclal sLrucL
ure of a company lf funds are ralsed for beLLermenLexpendlLure lL ls qulLe apparenL LhaL lL
wlll add noLhlng Lo Lhe earnlng capaclLy of Lhe company Such expendlLure may be lncurred
elLher ouL f funds ralsed by lssue of shares or sLlll beLLer ouL ofreLalned earnlngs buL ln
no case ouL of borrowed funds Cn Lhe oLher hand producLlve pro[ecLsmay be flnanced ouL of
borrowlngs also 8orrowlngs should never be used Lo meeL ouL losses unless Lhey are caused by
pauclLy of funds
(S) er|od of I|nance normally funds whlch are requlred for a shorL Llme say for 3 Lo 10 years
should be arranged Lhrough borrowlng because Lhese can easlly be repald as soon as
companys flnanclal poslLlon lmproves ln such cases shares should noL be lssued becau
se share caplLal excepL redeemable preference share caplLal cannoL be repald durlng Lhe llfe
Llme of Lhecompany even lf company ls ln possesslon of lLs own funds lssue of redeemable
preference shares Loo should be avolded ln such cases as lL requlres cerLaln legal
formallLles Cn Lhe oLherhand lf funds are requlred permanenLly or for a falrly long
Llme lssue of ordlnary shares should bepreferred
(6) L|ast|c|ty of cap|ta| structure 1he caplLal sLrucLure should be as elasLlc as posslble so as Lo
provlde for expanslon for fuLure developmenL or Lo make lL feaslble Lo reduce Lhe
caplLal when lL ls noL needed 1oo much dependence on debenLures and preference shares
fromLhe very beglnnlng makes Lhe caplLal sLrucLure of
Lhe company rlgld because of paymenL of flxedlnLeresL or dlvldend 1hese sources should
be kepL ln reserve for emergency or for expanslon purposes Cf course expanslon of funds ls
noL a problem and
lL can very easlly bedone elLher by lssue of fresh shares or debenLures or by obLalnlng loan f
rom flnanclal lnsLlLuLlons or from publlc buL conLracLlon of caplLal ls really a problem 1o
make lL feaslble debenLures whlch may be pald off afLer or wlLhln a flxed
perlod as per Lerms of lssue can belssued
(7) Nature of Investors An ldeal caplLal sLrucLure ls LhaL whlch sulLs Lhe needs ofdlffere
nL Lypes of lnvesLors havlng varylng flnanclal sLaLus and varylng psychologles
Some lnvesLors who prefer securlLy of lnvesLmenL and sLablllLy of lncome usually go ln for
debenLures reference shares wlll be preferred by Lhose who wanL a hlgher and sLable
lncomewlLh enough safeLy of lnvesLmenL LqulLy shares wlll be Laken up by Lhose who
are ready LoLake rlsks for hlgher lncome and caplLal appreclaLlon 1hose who wanL Lo acqulr
e conLrol overLhe affalrs of Lhe company llke equlLy shares
SecurlLy wlLh dlfferenL denomlnaLlons should be lssued Lo sulL Lhe flnanclal sLaLus of dlffere
nL persons ln order Lo secure subscrlpLlon from people ln dlfferenL sLraLa of socleLy
rlch mlddle andlower clasess
(8) Market Cond|t|ons CondlLlons of caplLal markeL have an lmporLanL bearlng on Lhecap
lLal sLrucLure of Lhe company because lnvesLor ls very ofLen lnfluenced by Lhe
general mood or senLlmenL of
Lhe caplLal markeL alLhough hls own mood or senLlmenLs gulde hlmLo lnvesL hls funds lor ex
ample ln Llmes of depresslon lnvesLor wlll look more for safeLy Lhan Lo lncome and wlll be
wllllng Lo lnvesL ln debenLure and noL ln equlLy
shares uurlng boom perlodwhen people have pleLhora of funds any Lype of securlLy can b
e sold easlly hence equlLles can have a beLLer markeL 1he managemenL whlle deslgnlng
Lhe caplLal sLrucLure of Lhe company musL waLch Lhe mood or senLlmenL of Lhe caplLal markeL
(9) Lega| kestr|ct|ons Lvery company has Lo comply Lhe law of Lhe counLryregardln
g Lhe lssue of dlfferenL Lypes of securlLles 1herefore hands of Lhe managemenL
are Lledby Lhese legal resLrlcLlons lor example ln lndla 8anklng companles are noL allowe
d Lo lssueany Lype of securlLles excepL equlLy shares under Lhe lndlan 8anklng Companles AcL
Agalnunder conLrol of CaplLal lssues AcL ln lndla has flxed 4 1 raLlo beLween debL and equlLy
and 3 1 beLween equlLy and preferred sLock WlLhln Lhls overall
framework Lhe managemenL shouldsLrlve Lowards caplLal sLrucLure
(10) o||cy of 1erm I|nanc|ng Inst|tut|on lf flnanclal lnsLlLuLlons offer credlL Lo Lhe
lndusLry on sLrlcLly resLrlcLlve Lerms and adopL harsh pollcy of lendlng Lhe managemenL wlll
glve more welghLage Lo manueverablllLy prlnclple and absLaln from borrowlng from Lhese
lnsLlLuLlonsand wlll arrange caplLal from oLher sources Cn Lhe oLher hand lf Lhe flnanclal
lnsLlLuLlons provlde credlL on sofL Lerms Lhe flrm wlll follow cosL prlnclple ln
obLalnlng funds from Lhese lnsLlLuLlons oneasy Lerms
(11) Stab|||ty of Larn|ng or oss|b|||t|es of kegu|ar and I|xed Income 1he sLablllLy of caplLal
sLrucLure of a company very much depends upon Lhe posslblllLy of regular and
flxedlncome Mr A S uewlng has propounded Lhree prlnclples ln Lhls regard
(a) lf company expecLs sufflclenL regular lncome ln fuLure debenLure should be lssue
d
(b) reference shares may be lssued lf company does noL expecL regular lncome buL lL
lshopeful LhaL lLs average earnlngs for a
few years may be equal Lo or ln excess of Lhe amounL ofdlvldend Lo be pald on such preferenc
e shares
(c) lf company does noL expecL any regular lncome ln fuLure lL should never lssue anyLy
pe of securlLles oLher Lhan equlLy shares

1he above facLors are lmporLanL Lo bear ln mlnd Lo devlse Lhe caplLal sLrucLure of acomp
any
(12) 1rends |n Cap|ta| Market CaplLal markeL condlLlons deLermlne noL only Lhe
Lypes of securlLles Lo be lssued buL also Lhe raLe of lnLeresL on debenLures flxed raLes of
dlvldends on preference shares and Lhe prlces of equlLy shares When lnvesLmenL funds decllne
beLLer ylelds and proLecLlon for preference shares are demanded When such funds
lncrease preference shares may be sold on Lerms more favourable Lo Lhe lssulng compa
ny
(13) Cost of Cap|ta| and Ava||ab|||ty of Iunds 1he exacL form of flnanclng ls aL
Llmes Lhe resulL of Lhe sLudy of comparaLlve cosLs of varlous Lypes of flnanclng ln relaLlon Lo
Lherlsk lnvolved and Lhe avallablllLy of varlous alLernaLlve forms of flnanclng ln a cerLaln slLua
LlondebenLures may be lssued because of
Lhelr cheapness and avallablllLy desplLe Lhe danger of flxedobllgalLon
(14) reva|||ng I|nanc|a| Statutes CovernmenL may also lnfluence Lhe scheme of
company flnance ln
more ways Lhan one for example Lhrough regulaLlon and LaxaLlon pollcleseLc 1hls facLor ls
of speclal slgnlflcance ln lndlan lndla companles Lhe raLes of lncome Lax are Lhe hlghesL ln Lhe
world Plgh raLes of corporaLlon Laxes puL a premlum on debL flnanclng as compared wlLh
equlLy or preference shares because whlle lnLeresL on
debenLures ls allowed as a deducLlonfrom Laxable lncome Lhe paymenL of dlvldend ls noL (
advanLage of 1ax Shleld)
(1S) Assets Structure AsseL sLrucLure also lnfluences Lhe sources of flnanclng ln several
ways llrms wlLh long llved flxed asseLs speclally when demand for Lhe ouLpuL ls
relaLlvelyassured can use longLerm debLs llrms whose asseLs are mosLly recelvables and
lnvenLory whose value ls dependenL on Lhe conLlnued proflLablllLy of Lhe lndlvldual flrm
can rely less longLerm debLflnanclng and more on shorLLerm funds
(16) Att|tude of management ManagemenL varles ln sklll [udgmenL experlenceLemper
amenL and moLlvaLlon lL evaluaLes Lhe same rlsk dlfferenLly and lLs wllllngness Lo
employdebL flnance also dlffers 1he caplLal sLrucLure Lherefore ls Lo a large exLenL equal
ly lnfluenced by Lhe age experlence amblLlon confldence and conservaLlveness of
Lhe managemenLs
(17) Lenders Att|tude SomeLlmes Lhe lenders aLLlLude ls also an lmporLanLdeLer
mlnanL of caplLal sLrucLure ln Lhe ma[orlLy of cases Lhe flrms managemenL dlscusseslLs
caplLal sLrucLure wlLh lenders and glves much welghL Lo Lhelr advlce 8uL where managemenL
ls Lhe confldenL of fuLure lL may use leverage beyond norms for Lhe lndusLry
(18) I|sca| Incent|ves and 1ax Concess|on lncenLlves and Lax concesslons belngprovlded
by Lhe governmenL Lo varlous Lypes of lndusLrlal unlLs llke relaxaLlon of securlLy
margln13 subsldy by Lhe CovernmenL of repaymenL perlod exLenslon beyond 10 years
gesLaLlon perlod 2 years reducLlon ln appllcaLlon Lo Lhe exLenL of 30 ln appllcaLlon ls
made for Lhe promoLlon ln background areas also affecL Lhe caplLal sLrucLure
(19) Adv|ce g|ven by I|nanc|ng Agenc|es Such agencles are speclallsed ln Lenderlng
experLflnanclal advlce concernlng Lhe caplLal sLrucLure of a flrm 1helr advlce should be
glven due welghL and conslderaLlon ln flnanclal plan of Lhe concern

1hus we see Lhe deLermlnaLlon of a sulLable paLLern of caplLal sLrucLure requlres a Lhor
oughconslderaLlon of a large number of facLors 1here can be no ldeal paLLern of caplLal
sLrucLure for all companles even ln Lhe same lndusLry So each company has Lo be
sLudled as an lndlvldualcase