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Capital structure Meaning:

Capital structure of a company means the composition of long term sources of funds, such as ordinary shares, preference shares, debentures, bonds, long term debts. it refers to the kind & proportion of securities for raising long term funds, it implies the determination of form or makeup of a companys capitalization.

Definitions:
o Robert H. Wessel: the term capitalization structure is frequently used to indicate the long term sources o f funds employed in a business

o Husband & Dockerary: capitalization embraces the composition or the character of te structure as well as the amount

o W. Gersterburg: the term capital structure is frequently used to indicate the long -term sources of funds employed in a business enterprise

o John .J. Hampton: capital structure is the combination of debt & equity securities that comprise a firms financing of its assets

o R .H .Wessel: The term capital structure is frequently used to indicate the long term sources of funds employed in a business enterprise.

Characteristics of capital structure


(1) Simplicity: A sound single capital structure attains simplicity in the initial stage by limiting the number of issues & types of securities. If the capital structure is complicated from the very beginning by issuing different types of securities, the investors hesitate to invest in such a company. The company may also face difficulties in raising additional capital in future. Thus it is advisable to issue equity & preference share in developing an optimum capital structure . Debentures & Bonds should be reserved for future financial requirements. (2) Flexibility: A flexible capital structure enables the company to make the necessary changes in it according to the changing conditions & make it possible to procure more capital whenever required or redeem the surplus capital. (3) Minimization of risk: An ideal capital structure should posses the quality of minimum risk . Risk s such as increase in taxes, rates of interest, cost etc. & natural calamities adversely affect the companies earnings. Therefore the capital structure should be devised in such a way as to enable it to afford the burden of these risks easily. (4) Minimization of cost : A sound capital structure should attempt to establish the security mix in such a way as the raise to requisite funds at the lowest possible cost. As the cost of various sources f capital is not equal in all circumstances, it should be ascertained on the basis of weighted average cost of capital . The management should aim at keeping the expenses of issue & fixed annual payments at a minimum in order to maximize the return to equity shareholders. (5) Maximization of return: A balanced capital structure should be devised in such a way as to maximize the profits of trading on equity so as to minimize the cost of capital. (6) Maximization/Retention of control: A sound capital structure retains the ultimate control of a company with the equity shareholder who have the right to elect directors. Due consideration should to be given to the question of control in management while deciding the issue of securities. The existing shareholders may not be able to retain control . If a large number f equity shares are issued the company should issue preference share or debentures instead of equity shares to the public because preference share carry limited voting rights & debentures do not have any voting rights. The capital structure of a company should be changed in such a way which would favorably affect the voting structure of the existing shareholders in increase their control on the companies affairs. Though the management of a company is apparently in the hands of a directors, indirectly, a company is controlled by equity shareholders who have the right to elect directors . As preference shareholders carry limited voting rights & debentures holders do not have any voting rights , a well devised capital structure

ensures the retention of control over the affair of the company within the hands of the existing equity shareholder by maintaining a proper balance between voting right & non-voting capital.
(7) Proper/Adequate liquidity: An objective of a balanced capital structure is to maintain proper liquidity which is necessary for the solvency of the company . A sound capital structure enables a company to maintain a proper balance between fixed & liquid assets & avoid the various financial & managerial difficulties.

(8) Full utilization : Optimum utilization of the avoidable financial resources in an important objective of a balanced financial structure enables the company to make full utilization of available capital by establishing a proper co-ordination between the quantum of capital & the financial requirements of the business. A balanced capital structure helps as company to eliminate both the states of over capitalization & which are harmful to the financial interest of the company.

Factors determining capital structure The capital structure of a company may be internal or external

(A) internal factors : nature of business Regularity of income Certainty of income desire to control the business Future plans Purpose of finance Attitude of management Trading on equity Debt capacity & extent of risk Cost of capital Capital gearing ratio Flexibility simplicity

(B)External factors :
Nature & kind of investors Conditions of capital market

Cost of capital
Present status & rules Possible changes in low

Internal factors

1. Nature of business: companies having stable earning can afford to raise funds through sources involving fixed charges, while other companies have to rely heavily on equity share capital .public utilities, extractive, financing & merchandising enterprises are more stable in their earning & enjoy greater degree of freedom from competition than industrial concerns

2. Regularity of income: Capital structure is affected by the regularity of income . If a company expects regular income in future, debentures bonds should be issued. Preference share may be issued if a company does not expect regular income but it is hopeful that its average earnings for a few years may be equal to or in excess of the amount of dividend to be paid such preference share.

3. Certainty of income: If a company is not certain about any regular income in future . It should never issue any type of securities other than equity shares.

4. Desire to control the business: If the control of the company is to retained within few hands a large proportion of funds within few hands ,a large proportion of funds is retained by issuance of non-voting right securities, such as debentures & preference shares . A majority of voting right securities i.e. equity shares are held by the promoters or their relatives to control the affair of the business. Thus majority of the funds are raised from public retaining the control of the company with the promoters or the control of the company with the promoters or the existing shareholders.

5. Future plans : capital structure of a company is affected by its development & expansion programmes in future. For this propose , the amount of author issued capital in kept higher sp that the requisite amount may be raised time of need . In the beginning the company collects capital by issuing shares. Therefore , capital structure is devised in accordance with future development & expansion programs. The requisite capital is raised by issuing preference share & debentures.

6. Purpose of finance: An important factor exterminating the type of capital to be raised is the purpose for which it is required. If funds are needed for some productive activity directly adding to the profitability of The company , capital may be raised by issuing securities bearing fixed charges like preference shares & debentures. On the other hand, retained earnings or equity share capital will be the better source of financing funds are needed for such purpose of financing funds are needed for such purpose as betterment maintenance, etc which do not directly add to the earning of the company

7. Attitude of management : Capital structure of a company is affected by the attitude of the management . Verifying in skill , judgment, experience temperament & motivation management evaluates the same risks differently & its willingness to employ debt capital also differ . Thus capital structure is influenced by the ago, experience, ambition , confidence & conservativeness of the management.

8. Trading on equity : Trading on equity means regular use of borrowed capital as well as equity capital in the conduct of a companies business. When a company employs borrowed capital including preference share capital to increase the rate of return on equity shares, it is said to be trading on equity . If the fixed rate of interest on borrowed capital or on dividend on preference share is lower than the general rate of earnings of the company , the equity shareholder, will have an advantage in the form of addiction divided . Therefore trading on equity implies the presence of a favorable financial leverage in the companys capital structure. . A company would prefer, to issue debenture or preference share having a rate of interest or dividend lower than the general rate of its earning.

(1) Cost of capital : cost of capital is an important determinant of Capital structure of a company . It influence the profitability & general rate of earnings. A company must select cost . It must raise capital fund by borrowings when rate of interest is low & by issuing equity shares when rate of earning s & share prices are high.

9. Debt capacity & extent of risk: The use of borrowed capital become risky for the company after a certain extent because it would lead to increase in the fixed liability of interest payment adversely affecting the companies income & reducing its liquidity. Excessive use of borrowed funds also endanger the solvency of the company in the long run. High debt equity ratio is particularly risky for the companies with uncertain irregular & inadequate earnings. Hence the determination of debt equity ratio of such companies should be in accordance with their debt capacity.

10. Capital gearing ratio : The ratio of equity share capital to the total capital is called Capital gearing When the ratio of equity share is low in total capital structure , it is called high gearing On the contrary when the ratio of equity shares in the total capital structure of a company is hi gh , it is called low gearing Stability in equity share price & goodwill of a company depends on adequate capital gearing. A high capital gearing ratio encourages speculation in shares of such a company & market price of share continues to fluctuate. Therefore , it is necessary for the promoters to determine the ratio of fixed cost securities ( preference share & debenture) & fluctuating cost securities (equity shares carefully)

External Factors

1. Nature & kinds of investors : An ideal capital structure is one which suits the needs of different types of customers. Its success largely depends upon the psychological conditions of different types of investors. Which some investors prefer security of investment & stability of income other prefer higher income & Capital appreciation . Hence , shares & debentures should be issued in accordance with the tastes & preference of all types of customers . To suit the financial status of various section s of the society , a company should issue different types of securities with different denomination.

2. Conditions of capital market : Conditions of capital market have a direct bearing on the capital structure. In times of depression the possibilities of profit arte the least & rate of dividend on equity shares comes down . Hence the investors would prefer to invest in debentures & not in equity shares. Therefore debentures should be issued in times of depression . On the contrary any type of security can be issued to raise the requisite funds during boom period when people have sufficient funds. Therefore equity shares should be issued during boom period.

3. Cost of capital :

the cost of capital issued also affects the capital structure of a company. Hence the capital structure should be designed in such a way as to minimize the commissions payable to brokers, middleman & underwriters or the discount payable on issue of debentures & bonds. To conclude a company should raise funds by issuing different types of securities in such a way would minimize the cost of capital issue.

4. Present status & rules : capital structure is also influenced by the status & rules prevailing in the country . In India banking companies act restricts a banking company from Issuing any type of securities other than equity shares. Control of capital issues act has fixed 4:1 ratio for debt & equity & 3:1 ratio for equity & preference share capital

5. Possible changes in law : Besides complying the legal restrictions a companys capital structure is also influence need by possible changes in the law of the country. For e.g. If a companys income taxed at a higher rate then the directors should issue debentures because the amt. of interest payable to debentures holders is deducted while computing the companys total income. Whereas it is a statutory deduction , dividend is not an accepted deduction.

Modes of changes in capital structure


i. Recapitalization : In capitalization a company increases or decreases its capital or brings any short of changes therein . It is also known as reconstruction. It may be effected by increasing or decreasing the existing capital

ii.

Readjustment :

Major changes in the composition of the financial plan are made. Under readjustment are included change of short term debts into long term debts, change in rates of interest, change in the face value of shares capitalization of accumulated reserves, etc. these changes are made by accompany in order to overcome the financial difficulties & attain its objectives.

iii.

Reconstruction :

reconstruction is undertaken to strengthen the deterioting financial position of the company & Give it a better opportunity to peruse its purpose instead of winding up its business.

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