The future progress of the business organization, depends upon the optimum capital structure, to a large extent, because it directly affects the financial strength of the business organization. So, there are many elements or factors affecting capital structure in businesses.
Hence, while planning and formulating it, all those factors and elements should be well considered, which affects it.
Hence, it is essential that these should be kept in view at the time of formulating capital structure.
Factors Affecting Capital Structure
The elements or factors affecting capital structure may be divided into the following parts:
1. Nature of Business
The nature of business has an important role in deciding the capital structure of any organization, because the proportion of fixed and working capital is decided, according to the nature of the business.
Generally, Institutions are of three types:
- In business Institutions, fixed capital is less than the working capital.
- The manufacturing institutions have sufficient fixed assets, to the mortgage. Hence, their loan taking capacity becomes high.
- Although banking and Financial Institutions do not have much-fixed assets. But, they can obtain loans, easily on the basis of their credit.
2. Future Plans
If the institution has future plans, then it has to keep my amount of authorized capital, so that it may be issued in the future, at the time of need.
Initially, capital is obtained through equity shares, but later on, capital is obtained through preference shares and debentures.
3. Property Structure of Business
In those Institutions, where use is of property, finances are raised through equity shares and debentures.
For example, in manufacturing Institutions and public utility services, etc.
On the contrary, in those Institutions for which working capital is more useful than the fixed assets, the finance is managed through preference shares, like in business institutions.
4. Capital Gearing Ratio
The ratio between the owner’s capital (equity shares) and other capital (preference shares and loan capital) is known as capital gearing ratio.
The institution may have high and low capital gearing ratios.
In those Institutions, where capital gearing ratio is high, equity shares have the possibility of speculations.
Hence, it is necessary for the promoters that while determining the capital structure, the mutual ratios of fixed cost bearing capital and variable cost bearing capital should be decided cautiously.
5. Attitude of Managers
Capital structure is deeply affected by the attitude of the managers also.
The ratio of share capital and debentures is decided, taking into consideration the capacity of the managers to bear the uncertainties and risks and their level of experience, etc.
6. Age of Institution
The age of the new Institutions is less and hence element of the risk therein is high.
Their reputation in the market is also low. As a result, they have difficulty getting loans.
Hence, they have to depend more on share capital. The old and reputed Institutions May arrange money through debentures and loans.
These institutions can arrange a higher proportion of capital through loans.
Any institution should issue debentures and bonds only when it’s income in certain and regular in the future.
When the money is required only for some time and not thereafter, redeemable preference shares should be issued.
When the income of the institution is uncertain then equity shares should be issued.
8. Size of Business
The small-sized institutions have limited credit and hence they have to depend more on share capital.
On the contrary, large-sized institutions have more credit and a big volume of fixed assets also.
Hence, they are in a position to raise funds easily through loans also.
In medium-size Institutions, generally, there is a good balance between the share capital and debentures.
9. Flexibility in Capital
Although exiting capital structure alone has an important role in financial management, even then the institution should have the desired provision of arranging capital according to the future requirements.
With advancement, progress and development of the institution, the needs of financial management of the institution go on increasing.
Hence, the institution has authorized capital in excess of the requirements, so that additional capital may be raised by issuing of the shares, if required, Along with it, the institution should also use redeemable preference shares in the capital structure, so that the capital may be procured when required.
10. Control on Business
If the managers of the institution are desirous of maintaining their complete control, then they will issue equity share capital, according to their sources.
By doing so, they will establish control of the institution, by keeping most of the equity shares in their control.
Remaining required finances will be managed by issuing preference shares and debentures.
11. Cost of Issuing Capital
Normally, the Businessman should keep the costs, like – underwriting expenses, commission, and discount, etc. at the minimum.
Hence, generally, preference is given to the issue of securities on whose issue, the cost is relatively low.
But, in practice, appropriate capital proportion and burden of the cost of capital on the company are also taken into consideration, besides the cost of the capital issue.
12. Environment of Capital Market
Capital markets are of development, boom, and depression.
The selling of shares become easier and developed and boom markets.
In such situations, the prices of the shares also remain quite high.
Hence, the issue of shares in very easy, but during the depression sale of shares is difficult. As a result, for capital, more dependence is on debentures and loans.
13. Seasonal Changes
The Institutions engaged in the production of flour, sugar, juice, pickle, etc. require a high amount of capital in a particular season.
Hence, in their capital structure, more attention should be paid on short-term loans.
If a high amount of long-term loans is included in the capital structure, the undue burden will increase in the lean season also.
14. A policy of Financial Institutions
Financial Institutions also influence or affecting the capital structure to a large extent.
This institution stresses keeping a certain loan capital ratio (generally in the ratio of 1:1).
Similarly, these institutions also keep the conditions of the alternative of converting a portion of their long-term assistance in equity share capital.
In such conditions, capital structure is influenced affecting by the terms and rules of these institutions.
15. Tax and Legal Provisions
Capital structure is also affected by the existing taxation system of the country.
An increase in the rates of Corporate tax issue of debenture in place of shares is regarded as more appropriate.
It’s the reason being that in respect of interests paid on debentures, deductions thereof permissible for from the profits and hence tax burden on the company gets reduced.
Besides, it is also essential to build the capital structure, by keeping in view the legal provisions.
Its reason is that the central government decides some guidelines under the capital issue act, which is to be compiled in toto.
16. Exiting Competition in Market
Prevailing competition in the market is also a factor affecting the capital structure.
Those Institutions which have to face the competition, get capital with difficulty and the profits there are also uncertain.
Hence, the sale of equity shares of such Institutions becomes difficult.
Hence, they have to fulfill their financial requirement by debentures and loans.
But, in the case of an industry with the moderate competition, capital is procured through the issue of share also.
17. Nature and Types of Investors
Some investors have an abundance of money, Whereas some others do not have much money.
Some investors are bold and remain ready to bear the risks, whereas others are desirous for the safety of their money and certainty of return over it.
Hence, the form of demand by various investors differs quite substantially.
Generally, bold investors make investments in equity shares, whereas cautions investors having less capital like to invest in preference shares and debentures. Some investors have shaky nature also.
For them, the issue of redeemable preference shares and convertible debentures are most suited.
18. Government Control
Capital structure is also affected by government control.
For example, under the capital issue act in India, In industries, other than capital-intensive Industries, the mix of loan and equity capital should essentially be in the ratio of 2:1.
The ratio of 3:2 in equity share capital and preference share capital is desirable.
Similarly, various restrictions exist on the issue of bonus shares.
Thus, Now You Know all the elements or factors affecting capital structure in business.