CAPITAL STRUCTURE

• According to Weston and Brigham, “Capital structure is the permanent financing of the
firm, by long-term-debt, preferred stock and common equity, but excluding all short-term
credit.
• Common equity includes common stock, capital surplus and retained earnings.”
OPTIMAL CAPITAL STRUCTURE
Various sources of long-term funds that aims at minimizing the overall cost of capital of
the firm and maximizes the market value of shares of a firm is known as ‘Optimal
capital structure’.
Characteristics
• An optimal capital structure must be simple to formulate and implement by the financial
executives.
• A sound capital structure must aim at obtaining the capital required for the firm at the
lowest possible cost.
• An ideal capital structure must have a combination of debt and equity in such a manner as
to maximize the firm’s profits.
• The capital structure must aim at retaining maximum control with the existing
shareholders.
• to have a sound capital structure, it is important that the various components help provide
the firm greater solvency through higher liquidity.
• The capital structure should be so constructed that it is possible for the company to carry
out any required change in the capitalization in tune with the changing condition.
• An ideal capital structure must be neither over capitalized nor under-capitalized.
• Capitalization must be based purely on the financial needs of the enterprise. An equitable
capitalization would help make full utilization of the available capital at minimum cost.
• The firm must attempt to secure a balanced leverage by issuing both debt and equity at
certain ideal proportions. It is best for the firm to issue debt when the rate of interest is
low.
DECISIONS ON CAPITAL STRUCTURE
The decisions regarding the use of different types of capital funds in the overall long-term
capitalization of a firm are known as capital structure decisions.
Any decisions on Capital Structure are based on different principles.
a. Cost Principle:
• The ideal capital structure is one that costs the least. The returns must be maximized, and
cost minimized.
• cost of capital of a firm is influenced by the amount of interest to be paid to its debenture
holders in a particular period.
• A firm would be advised to employ the debt capital, as it is a cheap source of funds.
• Using debt would give the firm a tax shield advantage. Such an arrangement is
technically known as ‘trading on equity’.
b. Control Principle
 The amount of control to be exercised by the shareholders over the management is
another an important principle underlining capital structure decisions.
 The finance manager, while making a fresh issue of capital funds, should ensure that the
control of the existing shareholders remain unaffected.
 The issue of bonds and preference shares offers the advantage of non-dilution of existing
ownership.
 However, debt funds costs interest burden and the consequent risk of bankruptcy.

c. Return Principle
 In this principle, the patterns of capital structure allow enhanced returns to the
shareholders.
 It also implies that the kind of capital source chosen must be secure.
 Besides, the principal amount to be returned immediately after the expiry of the stipulated
time period the bonds require debt servicing by way of fixed periodic interest.
 Hence, debt capital may prove fatal to the company in time of low/non-profits.
 In the context of risk, equity is the efficient capital structure.

d. Flexibility Principle
 There must be adequate flexibility in the capitalization.
 The addition of a capital fund must be such that, it should be possible for a firm to
redeem or add capital to the existing capital structure.
 It is important that the terms and conditions of raising funds be flexible.
 This would give the firm a more efficient capital structure.

e. Timing Principle
 The quality of decisions depends on the time at which the capital funds are either raised
or returned.
 This would minimize the cost of capital and help maximize returns to shareholders.
 Timing greatly affects the preferences and choices of investors, which in turn depends on
the economy.
 Accordingly, in periods of boom equity shares should be issued to raise resources.
 Conversely, in periods of depression, bonds are ideal, as they entail payment of lower
rate interest.

FACTORS AFFECTING CAPITAL STRUCTURE DECISIONS

A. Business activity:
• Business activity prevailing in the economy determines the capital structure pattern of a
firm.
• Due to e business expansion, the firm have several alternatives to source the required
capital to undertake profitable investment activities.
• Hence, it is advisable for a firm to undertake equity funding rather than debt funding.
B. Stock market:
 the capital market greatly influences capital structure decisions.
 capital market trends would help the firms decision on the quantity and cost of issue.
 Accordingly, if the stock market is expected to witness bullish trends, the interest rates
will go up and debt will become costlier.
c. Taxation:
• The rates and rules of taxation affect capital structure decisions.
• For instance, higher rates of taxation will be advantageous due to the tax deductibility
benefit of debt funding.
• Similarly, the taxes on dividend income, if any, would adversely affect the ability of
firms to raise equity capital.
C. Regulations:
• The regulations imposed by the state on the quantity, pricing etc. of capital funds to be
raised influences the capital raised by a firm.
• For instance, restrictions have been imposed by SEBI on the issue and allotment of shares
and bonds to different type of investors.
• A finance manager should take this factor into consideration while designing the capital
structure.
D. Credit policy:
• The credit policy made by the central monetary authority, such as the RBI, affects the
capital which is raised in the market.
• For instance, the interest rate liberalization announced by RBI has dominating the lending
policies of financial institutions.
• This affects the ability of finance managers to raise the required funds
E. Financial institutions:
• The credit policy followed by financial institutions determines the capital structure
decisions of firms.
• For instance, restrictive lending terms by financial institutions may deter firms from
raising long-term funds at reasonable rates of interest.
• Easy terms may encourage firms to obtain a higher quantum of loans.