Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business. In simple words, capital structure means the proportion of debt and equity used for financing the operations of business and it is calculated by the following formula: Capital structure = Debt/Equity.
Following factors are to be considered before determining capital structure.
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. Regulatory framework: Before determining the capital structure of a company, the guidelines of SEBI and concerned regulatory authority is to be considered.
7. 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.
8. 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.
