Capital Structure:
Capital structure refers to the mix between owners funds and borrowed funds. Owners fund consists of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures, public deposits, etc.
A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.
Factors Aecting Capital Structure:
1. Trading on Equity (Financial Leverage):
It refers to the use of fixed income securities such as debentures and preference capital in the capital structure so as to increase the return of equity shareholders.
2. Stability of Earnings:
If the company is earning regular and reasonable income, the management can rely on preference shares or debentures. Otherwise issue of equity shares is recommended.
3. Cost of Debt:
A firm’s ability to borrow at lower rate, increases its capacity to employ higher debt.
4. Interest Coverage Ratio (ICR):
The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. Higher the ratio, better is the position of the firm to raise debt.
5. Desire for control:
If the management has a desire to control the business, it will prefer preference shares and debentures in capital structure because they have no voting rights.
6. Flexibility:
Capital structure should be capable of being adjusted according to the needs of changing conditions.
7. Capital Market Conditions: In depression, debentures are considered good. In a booming situation, issue of shares will be more preferable.
