What is Capital structure? Discuss in detail the factors determining the Capital structure.

 

CAPITAL STRUCTURE

You have noticed that borrowing is desirable when profits are high. But it may be dangerous to depend on loans when profits decline. Then what should be the amount of borrowing for financing business activities? The general principle is to maintain borrowed capital and owners' capital in proper proportions. For a very successful business in favourable conditions, borrowed capital may be twice or even thrice as large as owners' investment. But for a business which is suffering from declining profits, the proportion of borrowed capital should be as low as possible.

Since borrowing of funds has distinct advantages, you may expect promoters to raise as large an amount as possible through loans. But beyond a certain limit borrowing may be risky. This is because fluctuation in earning and inadequacy of available cash could lead to a situation where.it may not be possible for the business to pay interest and repay the amount of loan. In that case, the financial position of the business is sure to be looked upon by suppliers and creditors as unreliable. They may stop extending credit, and in an extreme situation, the business may go bankrupt or insolvent. This danger arises basically on account of the fixed payments to be made on borrowed capital irrespective of the earnings and the shortage of available cash.

The proportion of fixed interest bearing capital in the total capital is known as capital gearing. The capital is, thus, said to be highly geared if borrowed capital is proportionately very high in relation to the ownership capital. Correspondingly, gearing of capital signifies a smaller proportion of borrowed capital compared with the ownership capital. The composition of the total capital consisting partly of long-term funds with fixed charge and partly of ownership funds is known as the capital structure. Thus, capital structure refers to the relative proportion in which various sources of long-term finance are used to meet the total financial requirements, like debentures and long-term loans, preference share capital, and equity capital (including reserves and surplus).

The funds raised to meet both the long-term and short-term capital requirements may take the form of ownership capital or borrowed capital. let us first understand these two terms before we talk of capital structure.

1-    Ownership Capital

The amount of capital invested in a business by its owners is known as Ownership Capital. It is on the basis of their investment that owners become entitled to the profits of the business. In a business under sole proprietorship, the individual owner normally invests capital from his own savings. In a partnership business, each partner contributes capital as mutually agreed among partners. Companies raise capital by issuing shares. Investors who contribute towards the share capital of a company become its owners by virtue of their share holding. They are entitled to receive dividend out of the profits earned by the company. The owners cannot claw to get any return on their investment unless there is profit. The rate of return on owners investment depends on the level of profits earned. If there is no profit, the owners go without any dividend. The risk of losses and of low rates of return are, thus, associated with ownership capital. Hence it is known as 'risk capital'.

Ownership capital may be used for financing fixed assets as well as continuous investment in current assets. Ownership capital is generally used as permanent capital or long-term capital. As risk-bearers, owners do not have any assurance whether they will get adequate returns on their investment or not. But they receive high returns if the business is successful. Besides, owners have a right to participate in the management of the business. A sole proprietor as also the partners of a business play an active part in running the business. Shareholders of companies do not manage the business directly. They elect members of the Board of Directors manage the affairs of the company on behalf of the shareholders.

2-     Borrowed Capital

The financial requirements of the business are often met by raising loans. Loans carry a certain fixed rate of interest which must be paid at regular intervals, half-yearly or yearly. There is also a commitment that the principal amount will be repaid in due course. Thus, if loan is raised for a period of 10, 15 or 20 years, its repayment may fall due at the end of that period or after stated intervals according to the terms on which the loan has been raised. Interest on loan is a fixed expense which has to be paid irrespective of the income. Thus, borrowing of money involves fixed obligation to pay interest and repay the principal amount as and when due.

 Money may be borrowed for short-term and long-term purposes i.e., to finance fixed assets as well as current assets. In a sole proprietor business the proprietor can borrow money on his personal security or on the security of his existing assets. A partnership firm can raise loans on the personal security of the individual partners whereby they become jointly and severally liable. Companies can also borrow either by issuing debentures or bonds, or raise direct loans.

If business income is stable and cash is realised from debtors regularly, raising of loan is not difficult. Hut if conditions are such that payment of interest is not possible as and when due, serious consequences may follow. There is loss of credit worthiness, that is, suppliers may not be prepared any more to supply materials on credit, further loans may not be forthcoming and lenders and creditors may even start legal action to recover their dues. Hence, borrowing money without the ability to meet the obligations of paying interest and repaying the principal is not desirable.

However, there are certain advantages of financing business activities with loans. If the business is profitable, interest being a fixed charge. the return on owners' investment is much higher. Suppose total investment in a business is Rs. 1 lakh out of which owners have contributed Rs. 40,000 and loans have been raised for the balance of Rs. 60,000 at 15% interest per annum. The profit earned during the year is Rs. 30,000. In this case, the total amount of interest payable is Rs. 9,000. So, profits after interest payment will amount to Rs. 21,000. Let us assume that tax is payable on profits at the rate of 50%. So. tax to be paid amount to Rs. 10,500. Net profit after tax will thus be Rs. 10,500. What will be the return on owner's capital? It will be Rs. 10,500 on their investment of Rs. 40,000 that is, 26.25%. Would it be so high if the owners had invested Rs. 1 lakh and there was no borrowings? Obviously not. Let us examine. Since no interest would be payable, tax would amount to Its 15,000(50% of Rs. 30,000). The net profit after tax would amount to Rs. 15,000 (total profit of Rs. 30,00(1minus Rs. 15,000 tax). The return on owners' capital would then be Rs. 15.000 on an investment of Rs. 1 lakh which works out to only 15%. You must have realised that owners got a higher rate of return when a part of the total investment was borrowed. If you examine all this carefully, you can notice two effects. Firstly, the amount of tax payable was less (Rs. 10,500 instead of Rs. 15000). Secondly, the payment on account of interest was fixed. Although loans helped in the expansion of business. nothing more was to be paid to lenders. The remaining profit was entirely for the owners. Use of borrowed capital to derive the benefit of higher rates of return on owners' investment is known as 'Trading on Equity’.

Factors Determining the Capital Structure

To what extent long-term funds should be raised from different sources so, as to determine the capital structure depends on a variety of factors. Let us now discuss about such factors.

1- Nature of the business:

 If a company is engaged in business activities in which sale, are subject to wide fluctuations, it is desirable to have a smaller proportion of borrowed funds. Companies manufacturing televisions, refrigerators, machine-tools and capital goods are normally subject to fluctuations in sales from time to time. If these companies have high debt ratios, they run the risk of facing financial distress during lean business due to their inability to discharge the fixed obligations. On the other hand, companies dealing in essential consumer goods of daily use or products having inelastic demand generally have stable earnings, and thus may depend to a greater extent on borrowed capital.

Competitiveness among companies is also another aspect of business which may affect the level of earnings. For instance, in the ready-made garment industry, competition among the firms is based on styles which are subject to frequent changes and mostly unpredictable. Hence, these firms rely less on borrowed capital and more on equity finance.

2- Characteristics of the company:

The size of a company as well as its credit standing also determines the extent to which equity or debt capital should be raised. Small firms have to depend more on owners' funds as it is difficult for them to raise long-term loans. This is because investors consider lending to small firms to be more risky. In contrast, large companies must make use of raising funds as no single source can meet their total financial requirements. Normally investors prefer to lend money to large companies as they believe that their money is safe and the risk is less with big business firms. Similarly, firms which enjoy high credit standing among investors and lenders are in a better position to raise long-term finance from different sources.

3- Management control:

Promoters who had major share holding and control the management of the company take into account the probable effect of raising funds through the issue of equity shares. Equity shareholders having voting rights can influence the policy decisions of the company or the selection of directors. But the persons who give loans do not have any right to elect directors or to participate in the management of the company. Hence the existing management group, in order to retain their control over management, prefer to raise additional finance through the issue of debentures and preference shares.

4- Cost of finance:

Since interest paid on borrowings is chargeable to profits before tax calculation, the cost of debt financing inevitably lower than the rate of earnings (i.e. profitability) on equity capital. Hence, it is always beneficial to raise part of the total financial requirement through long-term loans. With lower cost of debt financing, the overall (average) cost of financing is reduced, and the return on equity capital is higher. This is one of the important determinants of the capital structure.

5- Effect of debt on the earnings per equity share:

We have already explained now the return on equity share capital increases if borrowed capital is used. The effect of debt on the rate of return on equity (or earning per share) is known as 'trading on equity' or 'leverage effect'. Thus, in business ventures with assured prospect of rising income, there is greater emphasis on debt capital in the capital structure.

6- Expected earning in relation to interest charges:

Another factor determining debt-equity ratio is the estimated coverage of interest by profits. If the average earnings of the company are expected to be three to four times the amount of interest payable on borrowed capital, it may be considered safe to raise long-term loans rather than equity capital. Three to four times coverage of interest by earnings is regarded as a reasonable assurance that interest payment would be possible even if profits decline substantially.

7- Availability of cash (cash flow):

The ability of a business to discharge its fixed obligations depends essentially on the availability of liquid cash. Profits earned may be adequate to cover the fixed charges arising out of debt, but the firm may not have sufficient cash to pay as the income gets continually invested in the form of more inventory, book debts or even purchase of equipment, particularly, if it is a growing concern. Hence, besides profitability, it is necessary to estimate the cash flows before deciding on the proportion of debt in the capital structure.

 8- Flexibility of capital structure:

The capital structure decision is usually made by management keeping in view their ability to adjust the sources of funds. The scope of changing the capital structure in future happens to be a basic consideration. For instance, in case additional funds are needed, a firm which is already financed with heavy debt may be forced to issue equity shares with a higher cost of finance involved. Or, again if funds raised are to be refunded on account of declining business, a firm may be unable to do so if it earlier relied heavily on equity capital. Indeed, to preserve operating flexibility, it is desirable that every firm should have unused debt raising capacity for future use. On the other hand, there should be a judicious mix of debt and equity capital so that refund of debt is possible when necessary.

The most suitable capital structure known as optimal capital structure is planned taking into account the effect of alternative sources of financing and the mix of debt and equity capital which will maximise the wealth of the firm.