Financial Management Lecture 3 Capital Structure Date: 16/03/13

Factors affecting the capital structure of the firm. Two category of factors- internal factors and external factors. Internal Factors: 1. Fluctuating needs- A firm may have a particular busy season before any occasion such as Eid or Puja. So it requires extra money to conduct business. It would be expensive for the firm to use long-term financing that requires regular payment of interest or dividends. For fluctuating needs, the firm would prefer a short-term bank loan rather than issuing debt or equity securities. 2. Degree of risk- Debt security has a greater degree of risk than equity security because debt security requires to pay larger interest that could cause bankruptcy of the firm. But the equity security need not be repaid and dividends need not be declared. 3. Increasing ownership profits- If the firm can earn above the interest rate and all net profits above the interest rate can be distributed to the shareholders, the firm can go for debt security without increasing the investment of the shareholders. 4. Surrendering operational control- The sale of common stock brings new voting investment into the stock that causes the loss of operational control of existing shareholders. In this situation, the firm may have to decide to sell bonds or borrow from the banks to collect funds. 5. Future flexibility- Excessive debt reduces the ability of the firm to borrow in the future which reduces the flexibility of the firm. So, in order to ensure the flexibility of the capital structure, the firm should maintain a mixture of financing alternatives in the capital structure. External Factors: 1. General level of business activity- A rise in overall business activity may allow a firm to expand its business operations. It requires additional long-term funds. A decline in overall business activity may force a firm to reduce its operations so it may use its funds to retire debt and preferred stock. 2. Level of interest rates- Interest rates on bonds fluctuate in the market that depends on the demand and supply of bonds. If interest rates become excessive, funds delay long-term debt finance. It may switch to short-term funds until long-term debt can be offered at lower interest rates or switch to equity security. 3. Level of stock prices- Firms expect to receive as much money as possible through issuing new common stock. When stock prices are depressed, the firm does not issue the common stock. If the stock prices are high, the firm can raise relatively large amount of fund.

4. Availability of funds in the market- When there is a huge supply of money in the market and reasonably priced, debt and equity offerings can be sold. When money is scarce in the market, these offerings fail to sell out. 5. Tax policy on interest and dividends- Dividends are usually declared after paying tax. This tax policy makes the payment of dividends more costly to the shareholders. So it can discourage the shareholders to buy equity securities.