Capital structure refers to the mix of different sources of funds, including equity and debt, used by a company to finance its operations and investments. Capital structure is to achieve an optimal mix of debt and equity that minimizes the overall cost of capital while maximizing the firm's value and financial stability.
Following Internal and External factors are to be considered before determining capital structure.
Internal Factors
(i) Cash flow position: If cash flow position of the company is sound, then debt can be raised and if cash flow is not sound debt should be avoided and it must employ more of equity in its capital.
(ii) Interest coverage ratio: It is the ratio that expresses the number of times the Net profit before interest and tax covers the interest liabilities. Higher the ratio better is the position of the firm to raise debt.
(iii) Control: Issue of Equity shares dilutes the control of the existing shareholders, whereas issue of debt does not as the debenture holders do not participate in the management. Thus if control is to be retained, equity should be avoided.
(iv) Cost of debt: If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to equity.
External Factors
(v) Stock market conditions: If the stock market is bullish, the investors are adventurous and are ready to invest in risky securities. In this case, equity can be issued even at a premium. Whereas in the Bearish phase, when the investors become cautious, debt should be issued as there is a demand for fixed cost security.
(vi) Regulatory framework: Before determining the capital structure of a company, the guidelines of SEBI and concerned regulatory authority is to be considered.
(vii) Flexibility: Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances.
(viii) Tax rate: As interest on debt is treated as an expense, it is tax deductable. Dividend on equity is the distribution of profit so is not tax deductable. Thus if the tax rates are high, issue of debt is an attractive means as it is economical in nature.
