FACTORS INFLUENCING CAPITAL STRUCTURE/DETERMINANTS OF THE CAPITAL STRUCTURE
1. Financial leverage (or) Trading on equity
it is the make use of long term fixed interest bearing debt and Preference shares together with equity share capital. The make use of long term debt increases and magnifies the EPS if the firm yields a return higher than the cost of debt. This is positive leverage. though, if the firm yields a lower return than the cost of debt, it is Adverse leverage. EPS as well as increases with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing the tax, the lever- age impact of debt is more.
2. Growth & Stability of Sales
If the sales of a firm are expected to continue fairly stable, it can increase a higher level of debt, as the firm may not face any complexity in meeting its fixed commitments of interest repayment of debt. generally, greater the rate of growth of sales, greater can be the use of debt in the financing of a firm.
3. Cost of Capital
The capital structure should offer for smallest amount of overall cost of capital depending upon the risk involved, beyond the three sources of capital (equity, preference and debt capital), Debt generally is a cheaper source because of (1) fixed rate of interest (2) legal obligation to pay interest (3) priority in payment at the time of winding up of the company and (4) tax advantage. Preference capital is also lower in cost than equity because of lesser risk involved and fixed rate of dividend.
4. Cash flow ability to service debt
A firm which can produce stable and higher cash inflows can employ more debt in its capital structure as compared to one which has lesser and unstable ability to produce cash inflows
5. Nature and size of firm
Public utility concerns may employ more of debt because of their regular earnings. A large company can arrange for long term loans and also can issue equity or preference shares to be public. Small companies because of their inability to raise long term loans at reasonable rate of interest depend on own capital.
Issue of equity shares involves dilution of control of existing equity shareholders. therefore either debt or preference capital is issued.
Capital structure of the firm should be flexible and must be able to alternate one form of financing by another.
8. Requirement of Investors
The risk profile of the investors - institutional with private (risk averse, adventurous and indifferent investors) should be coordinated with the risk characteristics of the capital instruments that is issue of equity shares to adventurous investors, issue of preference shares to indifferent investors and issue of debt to risk averse investors.
9. Capital market conditions
If the share market is on boom period, it should issue equity shares. If it is depressed, the company should not issue equity shares.
10. Assets structure
If main portion of the total assets of a company comprises of fixed assets, the company can borrow long term debts.
11. Purpose of financing
if funds are required for unproductive purposes like general development on permanent basis, equity capital should be preferred. But If funds are required for productive purpose, debt financing is suitable.
12. Period of finance :
If funds are needed on permanent basis, equity shares or preference shares or Irredeemable debt must be issued. Otherwise, If funds are required for a limited period, Preference shares or Redeemable debentures should be issued.
13. Cost of floatation :
generally the cost of floating a debt is lower than the cost of floating equity.
14. Personal consideration :
When management is less experienced or less enterprising, they may go for equity. if management is experienced and enterprising, debt financing may be used.
15. Corporate tax rate :
If corporate tax rate is high, Companies prefer debt financing due to the tax ad- vantage on interest payment
16. Legal requirements:
The Government has issued fixed guidelines for the issue of shares and debentures and has laid down a frame work in which the capital structure decision has to be made.