Meaning of Capital Structure
Capital structure refers to the composition of various funds employed by a company for funding its long-term operations. It is simply defined as a particular combination of debt and equity used for meeting expenses of overall organizational activities and growth. The structure is more concerned with the manner in which the company acquires funds from distinct sources for carrying out its operations seamlessly. Capital structure is also called ‘financial leverage’ as every business for its continuity needs to decide the optimal ratio between equity and debt. Proper structuring of capital is the most critical aspect which corporate managers shall consider for enhancing the company’s value as well as shareholders’ wealth.
There are two main decisions covered under capital structure: The first one, involves choosing the type of security and the second one is concerned with deciding the proportion of each security type for reaching the perfect mix between debt and capital.
An equity share, preference shares, retained earnings, and long-term loans are distinct types of sources that assist a business in arranging its required amount of funds. A proper mix of funds from such multiple sources leads to the optimum capital structure which brings down the cost of capital and improves the company’s value in the market.
The capital structure generally varies from industry to industry. Industries involved in the banking and insurance business have a high amount of debt as part of their capital structure. Whereas, it is unsuitable to have a high proportion of debt for companies engaged in oil and petroleum extraction activities.
Kinds of Capital Structure
Various kinds of capital structure are discussed in the points given below: –
- Horizontal Capital Structure: Horizontal capital structure is one under which company has zero debt components in its capital structure mix. This structure is quite stable where firm expands in lateral manner, i.e., via equity capital or retained earnings only. There is lack of financial leverage in horizontal capital structure due to absence of debt component. All funds for project are brought in by owner only which reduces any chance of disturbance in structure.
- Vertical Capital Structure: Vertical capital structure is contrary to horizontal capital structure where debt capital forms large share in company’s capital. The equity share capital has small share in structure which serves as a foundation on which super structure of preference share and debt is built. Only debt is used for incremental addition in capital structure of firm. The structure due to high composition of debt raise financial risk of company and renders instability to structure. Here, firm is more vulnerable to hostile takeovers due to relatively less proportion of equity capital.
- Pyramid Capital Structure: This capital structure has higher proportion of equity capital and retained earnings which are ploughed backed into firm over large period of time. Pyramid capital structure is more oftenly employed by risk averse conservative firms having very low proportion of debt as compared to equity in their capital structure. The cost of share capital and retained earning is comparatively lower than cost of debt.
- Inverted Pyramid-shaped Capital Structure: Inverted pyramid-shaped capital structure is opposite of Pyramid shaped capital structure. The structure has small component of equity capital and retained earnings, but a higher component of debt. All increases in capital structure are brought via debt funds only. Such capital structure is highly vulnerable to collapse and mostly large organizations go for this type of structure.
Deciding on the right kind of capital structure is a key factor that needs to be considered prior to opt for the project. It is an essential element of financial analysis and has a great influence on deciding the success of a particular project.
Factors Determining The Capital Structure
The factors determining the decision related to the capital structure are as follows: –
- Risk of cash insolvency: The risk of cash insolvency arises when firm is unable to pay off its fixed interest liabilities. Company is necessarily required to do payments of debts carrying high interest rate irrespective of funds available or not if they include large proportion of debt in capital structure. In case, if these interest payments and principal amount is not paid on time then it results in liquidation of company. Company may also face insolvency situation if debt funds are withdrawn suddenly. Therefore, the risk factor plays an effective role in deciding the capital structure of firm and can be avoided if equity share capital is largely used for project financing.
- Size of the company: The size of company greatly influences the options available for raising funds. Raising of debt capital is difficult for small enterprises as compared to big enterprises because term and conditions of debentures/long-term loans is not favorable for small firms. The equity shares and retained earnings are only option on which small enterprises excessively depends. Whereas, on the other hand, big firms having stability and good image in market issues multiple type of securities and pays less interest rate to investors as compared to small or new firms. Investors prefer large organizations over small organization for doing investment due to their belief that large companies are less risky.
- Cost of capital: Cost of capital means expense need to be incurred for acquiring funds from distinct available sources in market. It is price which company pays for utilizing capital. A finance manager at the time of deciding capital structure must take into consideration the cost associated with each source of fund. It is also necessary for business to generate efficient funds for meeting cost of capital and funds for future growth. Debentures seem to be cheaper source of capital for companies generating adequate profit level as compared to equity share capital where extra share is demanded by shareholders in company’s profit.
- Degree of control: The preference of company with regard to retaining control of its activities plays great role in determining right capital structure. If company’s owner does not wish to dilute their control, then they will prefer more towards debt capital in comparison to equity capital, as debt funding carries no voting rights. The equity shareholders have maximum voting rights than preference shareholders and debenture holders. Therefore, capital structure consisting of loans and debentures is more suitable for companies whose management policies does not want to share the voting rights.
- Period of financing: Period of financing means the time period for which funds are required by business enterprise. A business willing to acquire funds for shorter term (say 6 months – 1 year) should go for loans from banks and other financial institutions. Whereas, if funds are needed for longer period of time, then issue of shares or debentures should be done.
- Capital market conditions: The conditions of capital market got an important influence over capital structure. At times of depression, loans and debenture are included into capital composition of companies. But during boom and inflation, capital structure is comprised of share capital which is in general the equity shares.
- Trading on equity: Trading on equity involves using fixed interest rate securities along with owner’s equity as source of finance. It is simply defined like an arrangement which focuses on raising the equity shareholders return by using securities carrying fixed rate of interest, i.e., preference shares and debentures. It is based on thought that equity shareholders are at advantage, if rate of company’s general earnings are higher than interest rate on borrowed capital and dividend on preference share. A company should always make an adequate mix of equity shares, preference share and debentures. Also, trading on equity becomes more crucial if expectations of shareholder become high.
- Need of the investors: The psychology and financial status of distinct types of investors is a key factor to be considered while deciding capital structure. Equity shares or preference shares that are generally of small denominations is only source of investment utilized by lower class or poor investors. On the other hand, debentures are of higher denominations which can only be afforded by financially sound investor. An investor of cautious nature will always prefer equity shares as he wants his capital to grow.
- Flexibility of financial plan: Capital structure of business enterprise should be such that there is always flexibility in raising funds as and when required. Availability of better flexibility offers space for expansion, both with regard to lower impact on cost and no major rise in risk profile. It is possible to refund debentures and loan as per the time requirements. Whereas, it is not possible to refund equity shares at any point of time which adds on rigidity. Therefore, for ensuring better flexibility in capital structure, company should go for loan options and debentures.
- Government policies: Capital structure of company is affected to greater extend by government policies, lending polices of financial institutions and, rules and guidelines of SEBI. This is because all these rules and polices totally determines the financial pattern of company. In addition to this, decision of capital structure also got influenced by monetary and fiscal policies.
Importance of Capital Structure
The importance of capital structure can be well-understood from the points given below: –
- Enhance value of firm: The foremost benefit provided by capital structure is maximization of firm value in market. Companies with optimum capital structure enjoys better goodwill as investors consider such companies most profitable one. This way shares prices of companies gets increased which ultimately results in enhancing the overall value of firm. Also, in presence of sound capital structure, firms are able to increase the ownership interest of shareholders.
- Maximizes return: A properly designed capital structure enables management in increasing the company’s profit leading to higher returns for equity shareholders. Returns are increased via utilizing mechanism of trading on equity under which high proportion of debt capital (cheapest source of capital) is included in capital structure. When rate of return on capital employed is greater then fixed interest rate to be paid to debt-holders, then company is said to be trading on equity.
- Brings down cost of capital: Sound capital structure provide another significant advantage of lowering the overall cost of capital. It is possible for firm to bring capital cost at lowest via deciding right mix of distinct funds. The cost is reduced by incorporating long-term debt capital in company’s capital structure. Cost associated with debt capital is quite lower than the cost of equity or preference share capital due to tax deductions provided on debt interest payments.
- Liquidity or solvency position: A business firm is easily able to maintain right liquidity position by deciding optimum capital structure. Sound capital structure that right amount of funds is acquired and utilized properly. It avoids any excess raising of debt capital as during times of poor earning, solvency get disturbed for compulsory interest payments to debt-supplier.
- Minimize financial risk: Business enterprises are able to decrease the financial risk by deciding right capital structure. Large involvement of debt component in capital structure increases the overall financial risk as with more debt capital, payment of fixed interest and repayment of principal debt amount increases. A firm saves itself from such risks by deciding judicious mix of debt and equity in capital structure.
- Efficient utilization of funds: Proper utilization of funds help business enterprises in earning desired level of profits. A capital structure which is well-designed enable companies in determination of financial needs and raise them from distinct sources in right proportion. Sound capital structure save firms from instances of under-capitalization and over-capitalization. With right planning and decisions related to make-up of overall capital, companies utilize the available amount of funds in best possible manner thereby yielding maximum returns.
- Makes company’s stock attractive: Right balancing of capital structure also help business enterprises in making their stock look more attractive. Every investor prefers to invest their money in companies having sound and well-balanced capital structure. It is because investors consider such organization have more chances of generating higher level of profit. When investors show more interest to these companies then ultimately their stocks price go up in market.
- Tool of tax planning: Effective tax planning is another key benefit provided by right capital structuring to firms. For companies opting for debt funds in their capital structure, gets benefit of tax deduction and saving which reduces the overall cost of capital. However, the dividend to be paid by company on equity and preference share capital are not deductible for tax purposes.