The ideal capital structure is determined by a firm’s financial manager. Deciding to take on debt or to issue more ordinary shares in order to finance business operations should be done after considering a lot of factors. Choosing debt means that a firm will have to pay back the debt with interest whether or not profit is made. Using equity to finance operations means that the firm will have to pay dividends if profits are made. Therefore, it is important for the financial manager to determine the right mix of debt and equity because too much debt can result in financial distress. Some of the factors affecting capital structure that should be considered are the size of the company, the nature of business and the debt to equity ratio among other issues.
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What is Capital Structure
Capital structure refers to the mix between debt and equity used to finance the long-term investment projects of a company. A firm can consider forgoing dividend payments in order to reinvest the earnings into the business for expansion, sell more shares or borrow funds from external stakeholders. In any case the company has to choose between debt and equity to finance its investment operations. The capital structure can be a mix of;
- Equity shares only, that is ordinary shares only
- Equity and preference shares only
- Equity and debentures only
- Equity, preference shares and debentures
The number of factors which affect the capital structure of an organisation are described below.
Size of The Company
The size of the company is one of the factors affecting capital structure; because large companies are considered less risky by many investors, their proportion of debt is likely to be larger. As for smaller companies, debt may be too expensive because they are charged higher interest rates as they are regarded riskier than large organisations. In addition, certain debt instruments such as bonds are only available to large organisations or government institutions.
The nature of Business
The nature of the business is another factor affecting the capital structure of an organisation. Monopolies can use debt because their guaranteed sales can generate enough revenue to cover the debt. Companies that sale food or basic commodities can rely on debt because, like monopolies there is always a demand for food and basic commodities. On the other hand, luxury goods producers may be better off using own capital or equity to finance their investments.
Government policy is an important factor affecting capital structure because any change in policies may affect the cost of borrowing. For example, an increase in the repo rate will increase the cost of debt, as a result companies may opt for equity. Also, a drop in the repo rate will have the opposite effect.
Debt to Equity Ratio
Also referred to as financial leverage, debt to equity ratio is another important factor affecting the capital structure of an organisation. If an organisation already carries too much debt taking more debt to finance investments may be risky and may be problematic in bad times.
Cash Position of the Firm
The cash flow position of the firm affects the make up of the capital structure. It is important to consider whether the company will be in a position to pay for interest or dividend payments as and when it needs to do so. If a firm does not generate regular cash flows, it will need to issue ordinary shares. However, if the firm has already issued all of its authorised ordinary shares it will not be able to issue more.
Other Factors Affecting the Capital Structure
- Market conditions
Capital markets are always changing. It is not advisable to issue shares during a bear market, instead a share should be issued during a bull run.
- Cost of Floating
The cost of floating either equity or debt is another important factor affecting the capital structure of an organisation. This is because the cost of floating equity is much higher than the cost of floating debt. The financial manager can consider debt but, other factors indicated above should be kept in mind.
- Regularity of earnings
Companies that have consistent revenue streams can use debt financing unlike firms whose income streams are not consistent. Also, a firm with a regular stream of income can have surplus earnings that can be used for its investment operations.
- Interest coverage ratio
The interest coverage ratio is a factor affecting the capital structure. It refers to the number of times a company’s earnings before interest and taxes cover the interest payments in the case of debt. A high interest coverage ratio means that companies can use debt to finance their projects, but a lower ratio means that a firm should consider other alternatives for financing.
- Debt Service Coverage Ratio
Debt service ratio is another factor affecting the capital structure of an organisation. Whilst the interest coverage ratio covers interest payments, the debt service coverage ratio covers the return on interest payments together with the principal amount. If the debt service coverage ratio is high a company can take more debt but if it is low other forms of financing should be considered.
- Return of Investment
The return on any investment is an important factor affecting the capital structure of a firm. If the return on an investment is higher than the interest payment, debt can be used but if the return on the investment is lower than the interest payments, borrowing to finance any investment will not be profitable.
- Tax Rate
High tax rate makes using debt to fund operations cheaper. This is because the interest paid on borrowed funds is subtracted from income before calculating tax. Equity becomes an expensive source of finance since the company has to pay tax on dividends paid out to shareholders. Thus, in countries that have high tax rates debt financing is cheaper that equity financing.
The issue of maintaining control in an organisation is also a factor affecting the capital structure of a firm. If the existing owners and shareholders of a company want to have complete control over their company, they should employ debt in their capital structure. This is because debenture holders have no say in the management of a firm and preference shareholder have limited rights to vote. Issuing more ordinary shares will mean that control is shared with new shareholders.