Factors affecting capital structure

Basics Factors that Influence a Company's Capital-Structure Decision The primary factors that influence a company's capital-structure decision are: 1.Business risk 2.Company's tax exposure 3.Financial flexibility 4. Management style 5.Growth rate 6.Market Conditions 1.Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad. 2.Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means offinancing a project is attractive because the tax deductibility of the debt payments protects some income from taxes. 3. Financial Flexibility This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has. The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top. 4.Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company'searnings per share (EPS). 5.Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise. 6.Market Conditions

Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.

In every business organization, capital is the main element to establish and run its business activities smoothly. Capital can be collected by using two sources. They are debt capital and equity capital. Debt capital is collected by issuing debentures; bonds etc and they are related with fixed cost of capital. Equity capital can be collected issuing different shares like common stock, preferred stock etc. In simple words, maintaining the balance or proportion of this capital is known as corporatecapital structure. So it refers to the combination of various sorts of securities through which funds are raised.

Sometimes some financial experts define it as all those capitals and liabilities, which are included in balance sheet. But actually it is not a realistic approach. Capital is related only with long term fund. Hence, Capital Structure = Financial Structure - Current Liabilities Capital structure may be defined as the mixture of debt and equity that comprises the financing of its assets. Hence, the total balance of capital and liabilities is financial structure, not a capital structure. The main objective of financial manager behind capital structure management is to minimize the overall cost of capital and risk, and take the advantage of favorable financial leverage and corporate tax. So while maintaining the proportion between debt and equity, their merits and demerits should be evaluated relatively. It is not possible to have an ideal capital structure, however, the management should target capital structure and initial capital structure should be framed with subsequent changes in initial capital structure to have it like target capital structure. Some companies do not plan capital structure but they are still achieving a good prosperity. There are significant variations in the capital structures of different industries and different companies. There are many factors that affect capital structure. Following are the basic factors which should be kept in view while determining the capital structure.

1. Growth and stability of sales Firms that are growing rapidly generally need larger amount of external capital. The floatation costs associated with debt are generally less than those for common stock, so rapidly growing firms tend to use more debt. At the same time, however, rapidly growing firms often face greater uncertainty which tends to reduce their willingness to use debt. Firms whose sales are relatively stable can use more debt and incur higher fixed charges than a company with unstable sales.

1. Competitive structure/ stability of profit margin. Firms with high rate of return on investment use relatively little debt. Their high rate of return enables them

to do most of their financing with retained earnings. If profit margin is constant more debt is used.

3. Cash flow ability The selection of capital structure is also influenced by the capacity of the business to generate cash inflows, stability, and certainty of such inflows. Regularity of cash inflows is much more important than the average cash inflows. A company with unstable and unpredictable cash inflows can no longer afford to depend on debts.

4. Cost of capital If the cost of capital is too high, borrowing is costly. So at that situation equity capital is preferable. As compared with other securities, the equity shares are more economical because they have least cost of capital. In the processing of trading, no more floatation costs, brokerage costs etc are incurred.

5. Control The consideration of retaining "Control" is also very important. The ordinary shareholder can elect the directors of the company. If company sells the commonstock, it will bring new voting investors into the firm, making the control difficult. To maintain control within the hand of limited members, a firm has to use more amount of debt or preferred stock because they have no management and voting right. If the firm wants to more equity shares the management right will be diversified. 6. Marketability or lender's attitude The term 'Marketability' refers to the readiness of investors to purchase a security in a give n period of time. The capital markets keep changing continuously. The capital structure will have to be customized to the attitudes of investors prevailing at the time of issue of capital. If investors demand preference shares, firm must have issue of preference share capital. Due to the changing market sentiments, the company has to decide whether to raise funds with a common shares issue or with a debt issue. 7. Size of the company The availability of funds is greatly influenced by the size of the enterprises. A small company finds it difficult to raise debt capital. The terms of debentures are less favorable to small companies so they have to rely on equity share and retain earning for funding business. Large companies are generally considered to be less risky by the investors and, thus, they can issue common shares, preference shares and debentures to the public. 8. Floatation cost Floatation costs take place only when the funds are externally raised. Floatation costs consist of some or all of the following expenses; printing of prospectus, advertisement, underwriting and brokerage etc. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may lure the company to issue debt than common shares. The company will save in terms of floatation cost if it raises funds through large issue of securities but the company should raise only that much of funds which can be employed profitably. In large companies flotation cost is not a significant consideration. 9. Development of capital market It's an important factor in capital structure. It refers to the extend which the capital market is developed (i.e. Equity or debt market). More developed equity market means more equity used and less developed equity means less equity used. Similarly, more developed debt market means more debt used and vice versa.

10. Growth opportunities The growth opportunities of business can be either tremendous or very low. Depending upon the growth opportunities the debt ratio fluctuates. Higher growth opportunities exist then higher debt is used otherwise vice versa.

11. Agency costs While determining capital structure, having least agency cost is preferred but if there is agency problem than debt is used largely for funding the business.

12. Other sources of tax shield In order to take the advantage of low tax, borrowing is preferable for a firm because interest is considered as deductible expenditure according to the income tax law. But dividends are not considered deductible expenses and they are paid out of profits after tax.

13. Level of economic development If the level of economic development is high then more debt is required. Level of economic development plays significant role in capital structure. In Nepal investors ar shifting to India. Since India is becoming economic giant, Nepali investors are also investing in Indian organization.

Internal factors
1. 2. 3. 4. 5. 6. 7. 8. 9. Financial leverage Risk Growth and stability Retaining control Cost of capital Flexibility Cash flows Purpose of finance Asset structure

External 1. 2. 3. 4. Size of the company Nature of the industry Investors Taxation policy

5. 6. 7. 8. 9. 10. 11. 12.

Level of stock price Conditions of capital market Availability of funds Level of business activity Interest rate Legal requirements Cost of inflation Period of finance