Risk of cash insolvency
Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the higher proportion of debt in capital structure compels the company to pay higher rate of interest on debt irrespective of the fact that the fund is available or not. The non-payment of interest charges and principal amount in time call for liquidation of the company. The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk factor has an important bearing in determining the capital structure of a company and it can be avoided if the project is financed by issues equity share capital.
Risk in variation of earnings
The higher the debt content in the capital structure of a company, the higher will be the risk of variation in the expected earnings available to equity shareholders. If return on investment on total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the shareholders get a higher return. On the other hand, if interest rate exceeds return on investment, the shareholders may not get any return at all.
Cost of capital
Cost of capital means cost of raising the capital from different sources of funds. It is the price paid for using the capital. A business enterprise should generate enough revenue to meet its cost of capital and finance its future growth. The finance manager should consider the cost of each source of fund while designing the capital structure of a company.
The consideration of retaining control of the business is an important factor in capital structure decisions. If the existing equity shareholders do not like to dilute the control, they may prefer debt capital to equity capital, as former has no voting rights.
Trading on equity
The use of fixed interest bearing securities along with owner’s equity as sources of finance is known as trading on equity. It is an arrangement by which the company aims at increasing the return on equity shares by the use of fixed interest bearing securities (i.e., debenture, preference shares etc.). If the existing capital structure of the company consists mainly of the equity shares, the return on equity shares can be increased by using borrowed capital. This is so because the interest paid on debentures is a deductible expenditure for income tax assessment and the after-tax cost of debenture becomes very low.
Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate of return on total capital employed exceeds the rate of interest on debt capital or rate of dividend on preference share capital, the company is said to be trading on equity.
Capital structure is influenced by Government policies, rules and regulations of SEBI and lending policies of financial institutions which change the financial pattern of the company totally. Monetary and fiscal policies of the Government will also affect the capital structure decisions.
Size of the company
Availability of funds is greatly influenced by the size of company. A small company finds it difficult to raise debt capital. The terms of debentures and long-term loans are less favourable to such enterprises. Small companies have to depend more on the equity shares and retained earnings. On the other hand, large companies issue various types of securities despite the fact that they pay less interest because investors consider large companies less risky.
Needs of the investors
While deciding capital structure the financial conditions and psychology of different types of investors will have to be kept in mind. For example, a poor or middle class investor may only be able to invest in equity or preference shares which are usually of small denominations, only a financially sound investor can afford to invest in debentures of higher denominations. A cautious investor who wants his capital to grow will prefer equity shares.
The capital structures of a company should be such that it can raise funds as and when required. Flexibility provides room for expansion, both in terms of lower impact on cost and with no significant rise in risk profile.
Period of finance
The period for which finance is needed also influences the capital structure. When funds are needed for long-term (say 10 years), it should be raised by issuing debentures or preference shares. Funds should be raised by the issue of equity shares when it is needed permanently.
Nature of business
It has great influence in the capital structure of the business, companies having stable and certain earnings prefer debentures or preference shares and companies having no assured income depends on internal resources.
The finance manager should comply with the legal provisions while designing the capital structure of a company.
Purpose of financing
Capital structure of a company is also affected by the purpose of financing. If the funds are required for manufacturing purposes, the company may procure it from the issue of long- term sources. When the funds are required for non-manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc. the company may procure it from internal sources.
When corporate income is subject to taxes, debt financing is favourable. This is so because the dividend payable on equity share capital and preference share capital are not deductible for tax purposes, whereas interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds. Moreover, a company has to pay tax on the amount distributed as dividend to the equity shareholders. Due to this, total earnings available for both debt holders and stockholders is more when debt capital is used in capital structure. Therefore, if the corporate tax rate is high enough, it is prudent to raise capital by issuing debentures or taking long-term loans from financial institutions.
The selection of capital structure is also affected by the capacity of the business to generate cash inflows. It analyses solvency position and the ability of the company to meet its charges.
Provision for future
The provision for future requirement of capital is also to be considered while planning the capital structure of a company.
If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is high from EPS point of view, debt financing is preferable to equity. If ROI is less than the interest on debt, debt financing decreases ROE. When the ROI is more than the interest on debt, debt financing increases ROE.