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:

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.

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.

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 share holders 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.

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

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.

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.

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.

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.
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:

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.

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.

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.

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.

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Factors Affecting the Cost of Capital
 
Controllable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has control over:

1. Capital-structure policy
2. Dividend policy
3. Investment policy

1. Capital Structure Policy

As we have been discussing above, a firm has control over its capital structure, targeting
an optimal capital structure. As more debt is issued, the cost of debt increases, and as
more equity is issued, the cost of equity increases.
2. Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule
can be changed. For example, as the payout ratio of the company increases the breakpoint
between lower-cost internally generated equity and newly issued equity is lowered.
3. Investment Policy
It is assumed that, when making investment decisions, the company is making
investments with similar degrees of risk. If a company changes its investment policy
relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of Capital

These are the factors affecting cost of capital that the company has no control over:

1. Level of interest rates

2. Tax rates

1. Level of Interest Rates

The level of interest rates will affect the cost of debt and, potentially, the cost of equity.
For example, when interest rates increase the cost of debt increases, which increases the
cost of capital.
2. Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.