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Capital Structure Capital structure is one of the most complex areas of financial decision making because of its interrelationship

with other financial decision variables. Poor capital structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projectsand thereby increasing the value of the firm. Capital structure is regarded as the proportion of debt and equity ..James C Vanhorn Capital structure is the permanent financing of a firm represented by long-term debt, preferred stock, common stock, but excluding all short-term credit Weston and Brigham The capital structure involves two decisionsa. Types of securities to be issued are equity shares, preference shares and long term borrowings (Debentures). b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into twoi. Highly geared companies- Those companies whose proportion of equity capitalization is small. ii. Low geared companies- Those companies whose equity capital dominates total capitalization. For instance - There are two companies A and B. Total capitalization amounts to be Tk. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Tk. 5 lakh, while in company B, ratio of equity capital is Tk. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company. So, Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. Optimal capital structure Optimal capital structure means a capital structure where cost of capital is minimum and value of the firm is maximum. Finance manager has to carefully design the capital structure because it affects the overall weighted average cost of capital of the firm and value. If weighted average cost is minimum then the value of the firm will be maximum. The optimal (best) capital structure is the set of proportions that maximize the total value of the firmSchall and Haley

The capital structure may be defined as the that capital structure or combinations of debt or equity that leads to maximum value of the firm.M.Y Khan and P.K. Jain The capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firms value is called optimal capital structure L.J Gitman Features of an appropriate capital structure Profitability: The most profitable capital structure is one that tends to minimize cost of financing and maximize earning per equity share. Return: The capital structure of the company should be most advantageous subject to other considerations it should generate maximum returns to the shareholders without adding cost to them. Risk: The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used otherwise its use should be avoided. Flexibility: The capital structure should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. Capacity: The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors fixed charges and principle sum. Control: The capital structure should involve minimum risk of loss of control of the company. The owners of closely-held companies are particularly concerned about dilution of control. Conservation: The debt content in the capital structure should not exceed the limit which the company can bear.

Factors Affecting Capital Structure Decisions Capital structure decisions are very important for companies to make. But there are always some other factors which firms take into consideration while making capital structure decisions. These factors are given below: Sales Stability: Firms consider this factor at the time of capital structure decisions. For example there are two firms; one having stable sales and other having unstable sales, the firm whose sale is relatively stable can safely take on more debt and incur fixed charge in comparison to the firm with unstable sales. For instance, the utilities companies use more financial leverage than industrial firms because they have stable sales Operating Structure: This is another factor which is involved in making capital structure decisions. A firm having less operating leverage can imply financial leverage in better way as it will have less business risk. Assets Structure: This factor may affect the capital structure decisions; there are two types of assets which are: general purpose assets and special purpose assets. The real state companies usually use general purpose assets as it makes good collateral. While the companies which are involved in technological research use special purpose assets because they are not highly leveraged. Profitability: The factor of profitability also plays an important role in capital structure decisions. The firms which get high rates of return on investment do not use high debt but they use relatively little debt. High rates of return on investment make them able to do financing with internally generated funds. Growth Rate: This factor plays an important role in capital structure decision making. It has been observed that faster growing firms mostly rely on external capital as the flotation costs exceeds. It is also possible that the firms relying on external capital may often face greater uncertainty due to which they may reduce their willingness to use debt. Control: There is great affect of control situation on capital structure decisions, because in such a situation management has 50% voting control between the debt and equity. If the management is not in a position to buy or purchase more stock, the other option for it is to use debt for new financing. But in a situation when the firms financial position is so week that the use of debt may cause serious risk of default then the control considerations could lead to use either debt or equity. Taxes: As far as interest is concerned it is no doubt a deductible expense which is much valuable to firms with high tax rates. This is the reason that many firms use much debt because if firms tax rate is higher the advantage is also greater. Management Attitudes: Different management attitudes may bring different changes in capital structure decisions. Management may be conservatives or aggressive depending upon the attitude towards risk taking. Both managerial styles exercise according to their own judgments and

analytical approaches about the proper capital structure. If the management attitude is conservative it uses less debt, where if the management is having aggressive approach then it uses more debt to get higher profits. Lender and Rating Agency Attitudes: Lenders and rating agencies also plays an important role in financial structure decisions. The corporations give much importance to the lenders and rating agencies. They make discussions about the capital structure and mostly act accordingly to their advice. Market Conditions: Capital structure also depends on market conditions; a firms optimal capital structure or favorable capital structure depends on long-term and short-term changes. Low rated companies which are in need of capital either go for the stock market or the short-term debt market without taking consideration of target capital structure. Financial Flexibility: Financial flexibility has also impact on capital structure decision. A firm or company makes the decision according to its financial flexibility. If a company is financially good it can raise capital with either stock or bond. But when its financial position is week the suppliers of capital make funds available if the company gives them a secure position in shape of debt. Seeking all above thoughts in mind it can be said that the companies should maintain the financial flexibility or adequate reserve borrowing capacity because it depends on the factors which are necessary in making capital structure decisions. Firms Internal Conditions: This is also one of the factors which affect the capital structure decisions. If a firm succeeds in completing any project then the probability of higher returns increase in the near future. Due to such internal conditions a company would not issue stock because the new earnings are neither anticipated nor reflected in the stock prices. So in such conditions the company or firm would give preference to finance with debt till the higher earnings are materialized or reflected in the stock prices.

Factors Determining Capital Structure Trading on Equity: The word equity denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of companys earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high. Degree of control: In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the companys management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. Flexibility of financial plan: In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. Choice of investors: The Companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. Capital market condition: In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. Period of financing: When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. Cost of financing: In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. Stability of sales: An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is

in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases. Sizes of a company: Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.