When deciding on the capital structure of a company, the promoters will have to decide the proportion of capital to be raised by the issue of shares and debentures.
It should be noted that shareholders are paid dividends out of profit, and so they bear the risk involved in carrying out the business activities.
According to Gertenberg, the capital structure (or financial structure) of a company refers to the make-up of its capitalization.
In a broader sense, capital structure includes all long-term funds, including share capital, debentures, bonds, loans, and reserves. Interest is paid on funds raised through loans irrespective of profit or loss.
Capital Structure: Definition
Funds obtained through shares and loans have their own plus and minus points.
Psychologically speaking, investors who desire a regular source of income typically invest their funds in debentures and loans. By contrast, adventurous investors tend to invest their funds in shares.
Companies, in order to capitalize themselves, seek to derive benefits from the psychology of both shareholders and debenture holders.
The company is said to be high-geared if a large part of its capital is raised through the issue of securities that carry a fixed rate of interest and dividends. The company is said to be low-geared if it is not required to pay interest and dividends at a fixed rate.
Suppose a company raises $1,500,000 by issuing shares and $1,000,000 by issuing debentures. By the above-mentioned definition, the company is said to be low-geared.
In this way, share capital obtained by issuing equity and preference shares, loans raised by issuing debentures, bonds, and loans, and retained earnings constitute the company’s capital structure.
Factors Determining Capital Structure
The following factors should be considered when determining the capital structure of a business enterprise:
1. Nature of the business: If the enterprise is a risky one, it should raise its funds by issuing shares. For example, manufacturing enterprises, where the degree of risk is considerable, secure capital by issuing of shares.
Trading concerns, which are inherently less risky than manufacturing companies, should obtain their funds by issuing debentures or receiving loans.
A financially sound business should raise its funds by issuing debentures. This is because such enterprises pay dividends at higher rates than the interest rate, and so issuing debentures is the most efficient option.
2. Purpose for which the finance is required: When funds are required to purchase fixed assets (or for unproductive purposes), funds must be raised by issuing of shares.
To meet working capital requirements, funds may also be raised through loans. If the purpose is to generate productive funds, the 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 satisfying the following requirements:
- The company should be reputed and established (e.g., a blue-chip company)
- The company should earn at rates higher than the interest rate prevailing in the capital market
- The company should have stable and regular earnings, thereby enabling it to pay interest on loans out of its earnings
- The company’s cash inflows must be assured
- The company must have sufficient fixed assets to offer in the form of security
4. Intention to retain control of the company: When the existing management wants to retain control over the company, it should obtain funds through loans. Issuing shares will mean granting voting rights to outsiders and losing control.
5. Cost of raising funds: Issuing equity shares is costlier than issuing preference shares and debentures. The company should compare the respective costs and make a suitable decision.
6. Period for which funds are required: Sometimes, funds are needed for the short- or medium-term, in which case borrowing through loans and debentures should be preferred.
When funds are required for a longer period as a permanent investment, equity shares should be issued.
7. Nature and attitude of investors: When investors are adventurous, equity shares should be issued, whereas if investors are cautious, debentures or preference shares should be issued.
When raising funds, the preferences and attitudes of investors should be taken into consideration. Ideally, the company should issue whatever its potential investors will willingly subscribe for.
8. Business cycle: If the business cycle is in a period of depression, investors will not be interested in subscribing to equity shares. In a boom period in the money market, investors are more likely to take risks and, consequently, invest in shares.
9. Statutory provisions: Legal requirements must be honored (e.g., banking companies can issue equity shares only).
10. Government taxation policy: Interest on loans and debentures is a deductible item under the Income Tax Act, whereas dividends are not deductible. To exploit this provision, companies may be tempted to issue debentures.
Difference Between Capitalization and 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 the make-up of the company’s 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 the arrangement of funds. It includes capital structure in itself.||Capital structure, in a broader sense, is an aspect of capitalization. It determines the ratio in which the total capital in the company is contributed by different sources.|
|Classification||Capitalization is classified as either over-capitalization or undercapitalization.||Capital structure is either high-geared or low-geared.|
|Influence||Capitalization is mainly influenced by the internal requirements of the enterprise.||Capital structure is mainly influenced by external forces, including market conditions, investor psychology, and government policies.|