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. Following are the factors which determine the
capital structure.
1. Nature of the business : If a company is engaged in business
activities in which sales 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 fluctuation 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 obligation. 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.
2. Characteristics of the company : The size of a company as well as its credit
standing also determine 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 firs to be more risky. In contrast, large companies must make use of
different sources 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 is inevitably lower than the
expected 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 on of the important determinants of the capital
structure.
5. Effect of debt financing on the
earnings per equity share: 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 structures.
