Determinants of Capital Structure¶
1. Trading on Equity and EBIT - EPS Analysis¶
The use of long-term debt and preference share capital, which are fixed income-bearing securities, along with equity share capital, is called financial leverage or trading on equity.The use of long-term debt increases the earnings per share (EPS) as long as the return on investment (ROI) is more than the cost of debt.But the leverage effect is more pronounced in the case of debt because of two reasons: 1. The cost of debt is usually lower than the other forms of capital. 2. The interest paid on debt is tax-deductible.
2. Stability and Growth of Sales¶
This is another important factor that influences the capital structure of a firm. The steadiness in sales ensures stable earnings, so that the firm will not face any difficulty in meeting its fixed obligations, viz. , interest payment and repayment of debt, so that it can raise a higher amount of debt. In the same way, the rate of growth in sales also affects the capital structure decision. Usually, higher the rate of growth in sales, greater can be the use of debt in the financing the firm.On the other hand, the firm should be very careful in employing debt capital if its sales are highly fluctuating and declining.
3. Cost of Capital¶
Cost of capital is also one of the important factors that should be kept in mind while designing the capital structure of a firm. Of all the sources of capital, equity capital is the costliest as the equity shareholders bear the highest amount of risk. On the other hand, debt capital is the cheapest source of capital because the interest on debt capital is tax-deductible, which makes the debt capital cheaper when compared to other forms of capital. Preference share capital is also cheaper than equity capital as the dividends are paid at a fixed rate on preference shares. Since the overall cost of capital is the aggregation of all specific costs of capitals, the capital structure should be designed carefully so that the overall cost of capital is minimized.
4. Cash Flow Ability¶
A firm which has the ability to generate larger and stable cash inflows will be able to employ more debt capital. The firm has to meet fixed charges in the form of interest on debt capital, fixed preference dividend, and the principal amount when it becomes due. The firm can meet these fixed obligations only when it has adequate cash inflows. Whenever a firm wants to raise additional funds, it should estimate the future cash inflows to ensure the coverage of fixed charges. Therefore, the calculations of fixed charges coverage and interest coverage ratios are relevant for this purpose.
5. Control¶
Sometimes, the designing of the capital structure of a firm is influenced by the desire of the existing management to retain control over the firm. Whenever additional funds are required, the management of the firm wants to raise the funds without any loss of control over the firm. If the equity shares are issued for raising funds, the control of the existing shareholders is diluted; hence, they may raise the funds by issuing fixed charge-bearing debt and preference share capital, as preference shareholders and debt holders do not have any voting right. Debt financing is advisable from the point of view of control, but excessive dependence on debt capital may result in a heavy burden of interest and fixed charges and may lead to the liquidation of the company.
6. Flexibility¶
Flexibility means the firm's ability to adapt its capital structure to the needs of changing conditions. The capital structure of the firm must be designed in such a way that it is possible to substitute one form of financing for another to economize the use of funds. Preference shares and debentures offer the highest flexibility in the capital structure, as they can be redeemed at the discretion of the firm. Thus, the capital structure should be flexible enough to raise additional funds whenever required, without much delay and cost.
7. Size of the Firm¶
The size of the firm influences the design of the capital structure of a firm. Small companies find it very difficult to mobilize long-term debt, as they have to prepare to pay a higher rate of interest and with inconvenient terms. Hence, small firms make their capital structure very rigid, and they have to depend more on equity capital and retained earnings for their requirements. Hence, the small firms sometimes limit the growth of their business, and any additional fund requirements are met through issuing equity or retained earnings only.
8. Marketability and Timing¶
Capital market conditions are not changed from time to time. Sometimes there may be depression and at other times there may be a boom condition in the market. The firm should decide whether to go for an equity issue or debt capital by taking market situations into consideration. In the case of depressed conditions, the firm should not issue equity shares but go for debt capital. On the other hand, under boom conditions, it becomes easy for the firm to mobilize the funds by issuing equity shares. The internal conditions of a firm may determine the marketability of securities. For example, a highly levered firm may find it difficult to raise additional debt.
9. Floatation Costs¶
Though this is not a very significant factor in the determination of capital structure, these costs are incurred when funds are raised externally. They include the cost of the issue of prospectus, brokerage, commissions, etc. Generally, the floatation costs are less in the case of debt raising rather than equity issues, which causes a temptation for debt capital. Floatation costs can be an important consideration in deciding the size of the issue of securities because these costs, as a percentage of funds raised, will decline with the size of the issue. Hence, the greater the size of the issue, the more will be the savings in terms of floatation costs.
10. Purpose of Funds¶
The purpose for which funds are raised should also be considered while determining the capital structure. If the funds are raised for a productive purpose, debt capital is more appropriate as the interest can be paid out of profits generated from the investment. But, if it is for an unproductive purpose, equity should be preferred.
11. Legal Restrictions¶
The various guidelines issued by the Government from time to time regarding the issue of shares and debentures should be kept in mind while determining the capital structure of a firm. These legal restrictions are very significant as they give a framework within which the capital structure decisions should be made.