Discuss the various features and determinants of an appropriate capital structure.
5 Important Features of an Appropriate Capital Structure of a Company
The important features of an appropriate capital structure of a company are as follows:
The term capital structure is used to represent the proportionate relationship between the various long-term kinds of capital arrangements – equity, debentures, preference shares, long- term debt, capital surplus, and retained earnings.
The term capital structure is part of financial structure, which includes both long-term and short-term funds. Analysis of capital structure involves the use of capital gearing (also called as capital leveraging or leveraging).
An appropriate capital structure should incorporate the following features:
1. Flexibility:
The consideration of flexibility gives the finance manager the ability to alter the firm’s capital structure with a minimum cost and delay, if warranted by the changed environment. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.
2. Profitability:
A sound capital structure should permit the maximum use of leverage at a minimum cost so as to provide better profitability and thus maximizing earnings per share.
3. Solvency:
Extensive debt threatens the solvency and credit rating of the company. The debt financing should be only to the extent that it can be serviced fully and also be paid back (if required).
4. Conservatism:
No company should exceed its debt capacity. As already explained that the interest is to be paid on debt and the principal sum is also to be paid. These payments depend on future cash flows. If future cash flows are not sufficient then the cash insolvency can lead to legal insolvency.
5. Control:
The capital structure should not lead to loss of control in the company.
Determinants of capital structure: capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Once a company has been formed and it has been in existence for some years, the financial manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure: Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance.
The factors to be considered whenever a capital structure decision is taken are: (i) Financial Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let it’s briefly explain these factors.
(i) Financial Leverage or Trading on Equity: The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known as financial leverage or trading on equity. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners' investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders' equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (BPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm's capital structure management. He can consider the possible fluctuations in EBIT and examine their impact
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