Introduction to capital structure Capital structure refers to the way in which a firm is financing its total assets, operations

and growth through issuing equity, debt and hybrid securities. Financing is process of collecting money through certain sources to be used on purchasing or maintain total assets, current operations of firm and any expected growth. Equity comes from issuing common stocks, preferred stocks and retained earnings while debt can be classified into long term debt e.g. long term note payable, bonds, debenture and short term debt i.e. short term bank loan, account payable. Beside these sources of finance, firms issue some hybrid securitiessecurities that possess the characteristics of both equity and debt such as income bond. Sources of equity that constitute the equity part of capital structure are quite different from each other. Common stock is major source of equity. Investors who buy common stock are called common shareholders. If firm earns net profit then it usually pays dividend to common shareholders. Common stocks do not have any maturity. Common shareholders have voting power to elect firms board of directors in this way they enjoy the control on organization. In the condition of liquidation common shareholder have claim on residual value after paying to creditors and preferred stockholders. From above discussion we can conclude that common stocks do not have any fixed income and maturityit means after they issued in primary market they can be traded in secondary market i.e. stock exchanges, over the counter market. Preferred stock can be defined as category of ownership in a corporation that has more claims on total assets and net income than common stock. Preferred stock has fixed dividend at the end each period usually a fiscal year irrespective to whether firm earns net profit or not. Some time preferred stock may be regarded as hybrid security because it possesses the characteristics of no maturity property of equity and fixed income property of debt. Unlike common stockholders, preferred stockholders do not have any voting power to elect board of directors. Retained earnings are third important source in equity portion of capital structure. Retained earnings refer to the portion of net income

that firm reinvests into business. Retained earnings enhance the stake of common shareholders because it is regarded as property of common stockholders.

Debt is amount borrowed by a firm to finance its business by issuing debt instruments. Firms usually pay interest on their debt at the end of each period e.g. annually, semiannually, quarterly etc. Interest is cost of debt for firm and fixed income for creditors. Debt has maturityrefers to time period until particular debt remains outstanding such as a 10-year bond, 20-year bond etc. Debt can be categorized as short term debt and long term debt. Short term debt is borrowing of firm that have maturity of one year or less such as short term bank loan, T-bill etc, while long term debt represents the debt that remains outstanding for more than one year for example, note, debenture, bond etc. Debt can also be classified as secured and unsecured debt. Secured debt is borrowing that pledge certain asset of firms as a security in condition of financial distress such as collateral. Unsecured debt is borrowing that does not pledge any asset of firm such as note and debenture (Ross et al 2008). The instruments differ by maturity, interest rate (fixed or floating), currency, seniority, security, and whether the debt can be converted into equity. Hybrid securities are particular type of securities that possess the characteristics of equity and debt i.e. convertible bond, income bond. Convertible bonds are bond that can be converted into equity before maturity and any change in price of shares affects convertible bond. Income bonds have fixed maturity but are paid interest if firm earns sufficient income. We regard hybrid securities as debt because they possess characteristics of either fixed income that is tax deductible and fixed maturity.

Goals / Principles of Capital Structure Management: For considering the suitable pattern of capital structure, it is necessary to consider certain basic principles which are militant to each other. It is necessary to find a golden mean by giving proper weight age to each of them. (I) Cost Principle: According to this principle, ideal capital structure should minimize cost financing and maximize earnings per share. Debt capital is a cheaper form of capital due to-two reasons. First, the expectations of returns of debt capital holders are less

than those of Equity shareholders. Secondly, interest is a deductible expenditure for tax purposes whereas dividend is an appropriation. (2) Risk Principle: According to this principle, ideal capital structure should not accept unduly high risk. Debt capital is a risky form of capital, as it involves contractual obligations as to the payment of interest and repayment of principal sum irrespective of profits or losses of the business. If the organization issues large amount of preference shares, out of the earnings of the organization, less amount will be left out for equity shareholders as dividend on preference shares is required to be paid before any dividend is paid to equity shareholders. Raising the capital through equity shares involves least risk as there is no obligation as to the payment of dividend. (3) Control Principle: According to this principle, ideal capital structure should keep controlling position of owners intact. As preference shareholders and holders of debt capital carry limited or no voting rights, they hardly disturb the controlling position of residual owners. Issue of equity shares disturbs the controlling position directly as the control of the residual owners is likely to get diluted. (4) Flexibility Principle: According to this principle, ideal capital structure should be able to cater to additional requirements of funds in future, if any. E.g. if a company has already raised too heavy debt capital, by mortgaging all the assets, it will be difficult for it to get further loans inspite of good market conditions for debt capital and it will have to depend on equity shares only for raising further capital. Moreover, organization should avoid capital on such terms and conditions which limit company's ability to procure additional funds. E.g., if the company accepts debt capital on the condition that it will not accept further loan capital or dividend on equity shares will not be paid beyond certain limit, then it looses flexibility.

(5) Timing Principle: According to this principle, ideal capital structure should be able to seize market opportunities, should minimize cost of raising funds and obtain substantial savings. Accordingly, during the day of boom and prosperity, company can issue equity shares to get the benefit of investors' desire to invest and take the risk. During the days of depression, debt capital may be used to raise the capital as the investors are afraid to take any risk. Factors affecting Capital Structure: Before deciding the mix of long term sources of funds, it is necessary to consider a lot of factors which can be broadly classified as: (a) Internal factors (b) External factors (c) General factors (a) Internal factors: (1) Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of the capital should be capable of earning the revenue enough to meet the cost of capital. It should be noted here that the borrowed funds are cheaper than the equity funds so far as the cost of capital is concerned. This is because of two reasons: (a) The interest rates (i.e. the form of return on the borrowed capital) are usually less

than the dividend rates (i.e. the form of return on the equity capital). (b) The interest paid on borrowed capital is an allowable expenditure for income tax

purposes while the dividends are the appropriate out of the profits. (2) Risk Factor: While planning the capital structure, the risk factor consideration inevitably comes into picture. If the company raises the capital by way of borrowed

capital, it accepts the risk in two ways. Firstly, the company has to maintain the commitment of payment of the interest as well as the installments of the borrowed capital, at a predecided rate and at a predecided time, irrespective of the fact whether there are profits or losses. Secondly, the borrowed capital is usually the secured capital. If the company fails to meet its contractual obligations, the lenders of the borrowed capital may enforce the sale of assets offered to them as security. On the other hand, if the company raises the capital by way of equity capital, the risk on the part of the company is minimum. Firstly, as dividend is the appropriation of the profits, if there are no profits, the company may not be paying the dividend for years together, Secondly, the company is not expected to repay the equity capital, unlike borrowed capital, during the lifetime of the company. Thirdly, the company is not required to offer any security or mortgage its assets for raising the funds in the form of equity capital. (3) Control Factor: While planning the capital structure and more particularly while raising additional funds, the control factor plays an important role, especially in case of closely held private limited companies. If the company decides to raise the long term funds by issuing further equity shares or preference shares, it dilutes the controlling interest of the present shareholders / owners, as the equity shareholders enjoy absolute voting rights and preference shareholders enjoy limited voting rights. The control factor usually does not come into the picture in case of borrowed capital unless the lender of the long term funds, i.e. Banks or financial institutions, stipulate the appointment of nominee directors on the Board of Directors of the company. (4) Objects of Capital Structure Planning: While planning the capital structure, the

following objects of the capital structure planning come into play. (a) To maximize the profits of the owners of the company. This can be ensured by issuing the securities carrying less cost of capital.

(b) To issue the securities which are easily transferable. This can be ensured by listing the securities on the stock exchange. (c) To issue the further securities in such a way that the value of shareholding of the present owners is not affected. (b) External Factors (1) General Economic Conditions: While planning the capital structure, the general economic conditions should be considered. If the economy is in the state of depression, preference will be given to equity form of capital as it will be involving less amount of risk. But it may not be possible always as the investors may not be willing to take the risk. Under such circumstances, the company may be required to go in for borrowed capital. If the capital market is in boom and the interest rates are likely to decline in further, equity form of capital may be considered immediately, leaving the borrowed form of capital to be tapped in future. It may also be possible to raise more equity capital in boom as the investors may be ready to take risk and to invest. (2) Level of Interest Rates: If funds are available in the capital market, only at the higher rates of the interest, the raising of capital in the form of borrowed capital may be delayed till the interest rates become favorable. (3) Policy of Lending Institutions: If the policy of term lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital, but the equity capital form should be tapped. (4) Taxation Policy: Taxation policy of the Government has to be viewed from the angles of both corporate taxation and as well as individual taxation. The return on borrowed capital i.e. interest is an allowable deduction for income tax purposes while computing taxable income of the company, while return on equity capital i.e. dividend is

not considered like that as it is the appropriation out of the taxable profits. As far as individual taxation is concerned, both interest as well as dividend will be taxable in the hands of lender of the capital subject to specified deductions available for the purposes. (5) Statutory Restrictions: The statutory restrictions prescribed by the Government and various statutes are required to be taken into consideration before the capital structure is planned. The company has to decide the capital structure within the overall framework prescribed by the Government and various statutes. (c) General Factors: (1) Constitution of Company: While deciding about the capital structure, the constitution of the company plays an important role. In case of private limited company, the control factor may be more important while in case of public limited company, cost factor may be more important. (2) Characteristics of Company: Characteristics of the company, in terms of size, age and credit standing play very important role in deciding capital structure. Very small companies and the companies in their early stages of life have to depend more on the equity capital, as they have limited bargaining capacity, they can't tap various sources of raising the funds and they do not enjoy the confidence of the investors. Similarly, the companies having good credit standing in the market, may be in the position to get the funds from the sources of their choice. But this choice may not be available to the companies having poor credit standing. (3) Stability of Earnings: lf the sales and earnings of the company are not likely to be stable enough over a period of time and are likely to be subject to wide fluctuation, the risk factor plays more important role and the company may not be able to have more borrowed capital in its capital structure as it carries more risk. However, if the earnings and sales of the company are fairly constant and stable over the period of time, it may afford to take the risk, where the cost factor or control factor may play important role.

(4) Attitude of the Management: lf the attitude of the management is too conservative, the control factor may play an important role in capital structure decision. If the policy of the management is liberal, the cost factor may get more importance.