Capital Structure | How to Determine the Capital Structure
While deciding the capital structure of the company the promoters will have to decide the proportion of capital to be raised by issue of shares and debentures. It should be noted that shareholders are paid dividend out of profit so they bear the risk involved in carrying out the business activities.
According to Gertenberg, capital structure of a company (or financial structure) “refers to the make up of its capitalization.” In a border sense, capital structure includes all the long term funds consisting of share capital, debentures, bonds, loans and reserves. Interest is paid on funds raised through loans irrespective of profit or loss.
Definition of Capital Structure
Funds obtained through shares and loans have their own plus and minus points. Investors with psychology of regular source of income invest their funds in debentures and loans. Those persons, who are adventurous by nature invest their funds in shares. The company in order to capitalize itself tries to avail of the benefits from the psychology of both the shareholders and debenture holders.
The company is said to be high geared, if large part of its capital is raised through by the issue of securities carrying fixed rate of interest and dividend. The company is said to be low geared, if it is not required to pay interest and dividend at fixed rate.
For example, if a company raises $15,00,000 by issue of shares and $10,00,000 by issue of debentures it will be said to be low geared. In this way, share capital obtained by issue of equity and preference shares, loans raised by issue of debentures, bonds and loans and the retained earnings constitute capital structure.
Factors Determining Capital Structure
Following factors should be taken into consideration while determining the capital structure of the business enterprise:
1. Nature of the business enterprise. In case the enterprise has more risk, it should raise its funds through issue of shares. A manufacturing enterprise, where the degree of risk is more subscribed secure its capital through issue of shares. In the same way trading concerns, which have lesser risks should obtain their funds through issue of debentures or borrow loans. A financially sound business enterprise should raise its funds through issue of debentures, because such enterprises are paying dividend at rates higher than the rate of interest, which they will have to pay.
2. Purpose for which the finance is required. When the funds are required for the purchase of fixed assets or for unproductive purposes funds must be raised through issue of shares. In order to meet working capital requirements, funds may be raised through loans. If the purpose is productive funds should be raised through borrowings.
3. Trading on equity. Trading on equity means borrowing funds at
reasonable rates with the help of share capital. The policy of trading on equity may
be adopted only by those business enterprises, which satisfy the following requirements
- It should be reputed established enterprise.
- It should earn at rates higher than the interest rate, prevailing in the capital market.
- The enterprise should have stable and regular earnings, so that it should be able to pay interest on loan out of its earnings.
- It should have assured cash inflow.
- The enterprise must have sufficient fixed assets to offer as security.
4. Intention to retain control of the company. When the existing management wants to retain the management and control of the company, it should obtain its funds through loan, because issuing shares will mean granting voting rights to outsiders and risking own control.
5. Cost of raising funds. Issuing equity shares is costlier than the issue of preference shares and debentures. The company should compare cost and take decisions accordingly.
6. Period for which funds are required. Sometimes funds are required for short or medium period borrowing through loans and debentures should be preferred. When funds are required for longer period as permanent investment equity shares should be issued.
7. Nature and attitude of investors. When investors are adventurous, equity shares should be issued, if investors are cautions debenture or preference shares should be issued. While raising funds, investors’ preference and attitude should be taken into consideration and the company should issue, what the investors would willingly subscribe for.
8. Business cycle situations. When it is a period of depression, investors will not be interested in subscribing equity shares. In case boom is prevailing in the money market, investors will be prepared to take risks and invest in shares.
9. Statutory Provisions. Legal requirements must be honored, such as Banking Companies can issue equity shares only.
10. Government Taxation Policy. Interest on loan and debentures is deductible item under Income Tax Act, whereas dividend is not deductible. In order to take advantage of this provision, companies may be tempted to issue debentures.
Difference Between Capitalization and Capital Structure
|Points of Difference||Capitalization||Capital Structure|
|Meaning||Capitalization in a narrow sense is the sum total of capital raised through shares, debentures, bonds, loans and retained earnings.||Capital structure is make up of the capitalization, i.e., shares, debentures, bonds, loans etc.|
|Meaning (Broader Sense)||Capitalization in a broader sense refers to the determination of the total needs of capital, its structure and arrangement of funds. It includes capital structure in itself.||Capital structure in a broader sense of capitalization is the part of capitalization. It determines the ratio in which the total capital contributed by different sources.|
|Classification||Capitalization is classified as over-capitalization and undercapitalization.||Capital structure maybe high
geared and low geared.
|Influence||Capitalization is mainly influenced by the internal requirements of the enterprise.||Capital structure is mainly influenced by external forces such as market conditions investors’ psychology and government policies etc.|
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.