UNIT – 3

FINANCING DECISION

Meaning of Capital Structure

Capital structure is the permanent financing of the firm represented by long term debt,
preferred stock, and net worth.

Or

Capital structure means the make – up, form, composition or mix of the capitalisation of
a business

Or

Capital structure means the mix up of the different sources of long term funds, such as
equity shares, preference shares, retained earnings, debentures and other long term loans
in the total capitalisation of a company.

Or

Capital Structure of a company refers to the composition of its capitalization and it

includes all long term capital sources viz loans, reserves, shares and bonds.

Factors affecting of Capital Structure /Determinants of capital structure:

The determinants of capital structure of an organization are divided into two categories.
They are

Internal Factors

1. Financial leverage/Trading on Equity :

Trading on equity means taking advantage of equity shares capital as a base to
raise funds through the issue of preference shares , debentures on reasonable terms
to ensure higher return on equity share capital.
Or

The use of borrowed funds, or preferred stock, for financing is known as trading on
equity.
 2. Risk

Ordinarily, debt securities increases the risk, while equity shares reducės it. A fim can
avoid or reduce the risk, if it does not employ debt capital in the capital mix, But, it
reduces the return to equity shareholders. Hence the finance manager must employ the
debt in such a way, that the benefit of that should maximize the return to equity
shareholders

3. Growth and stability :

In the initial stages, a firm can meet its financial requirements through long-term sources,
particularly by raising equity shares. If growth of the company is good and the fim is
maintaining stability in its profit and sales it can raise the debts and even the fim can
make use of retained earnings for its financial requirements.

4. Retaining the control :

The attitude of the management towards retaining the control over the company will have
direct impact on the capital structure. If the management of the company wants to have
maximum control over the management, they may issue only prefer shares or debentures
and not equity shares.

5. Cost of Capital :

The different sources of capital have different interest rates and preference shares carry
fixed rate of dividend. Therefore, different type of sources of funds will have different
cost. Debt is cheaper source when compared to other sources. to total capital can be
maximized by increasing the position of debt out of capital structure. Careful decision has
to be made in selecting the size of debt because more debt may increase the risk of a firm.
Hence cost of capital influences capital structure.
6. Cash flows: Cash flow ability will have direct impact on the capital structure.
Cash flow generation capacity of a firm increases the flexibility of finance
manager in deciding the capital structure. If cash flow ability is good, more debt
capital can be used which will reduce the cost of capital and increase the flexibility
of finance manager in deciding the capital structure, It cashinflow ability is good,
more debt capital can be used which will reduce the cost of capital and increase
the return to equity shareholders

7. Flexibility: Flexibility Means firm's ability to adopt its capital structure to the
needs of changing conditions, its capital structure should be flexible, so that
without much practical difficulty a firm can change the securities in capital
structure.

8. Purpose of Finance : The purpose of finance is another factor influencing capital

structure. If the funds are required for production purpose debt financing is
preferred, is interest can be paid out of profits. But if the funds are required for
fixed assets, equity capital is preferred.

9. Asset structure: Asset structure consists of fixed assets and current assets, usually
fixed assets are financed by long term sources like equity capital debentures and
preference shares and current assets are financed by short term sources. Hence the
cts structure will influence in the capital structure.
2) External factors:

1. Size of the company. If the size of business is small, the requirements of finance
are too little. if the size of business of firm is large, the amount of capital is
required.

2. Nature of Industry: A capital intensive industry engaged in manufacturing iron

and steel products may have high equity and less debt capital. On the other hand a
trading company, which has less asset structure, has to depend mainly on equity or
preference capital to meet their capital requirements.

3. Legal Requirements: Legal requirements have to be considered while deciding

the capital structure. For example guideline of SEBI regarding maintenance of
debt equity ratio, current ratio, promoter’s contribution etc. so legal requirements
will have impact on capital structure of any organization.

4. Period of Finance: The period for which the funds are required will have direct
impact on capital structure. If the funds are required for long term equity
shares,preference shares and debentures may be preferred. On the other hand if
funds required for short term, debts capital is preferred.

5. Level of interest rate: The interest rate is having direct impact on capital
structure. Is the expectation of the banker or financial institutions is to get high
rate of interest a firm can postpone the mobilization of funds or can make use of
retained earnings

6. Level of Business Activity: Additional fund When a level of business activity of a

fimis rising, require more finds for expansion and diversification. The company
may opt for raising additional funds through the issue of debentures, preference
shares, or it can borrow term loans. Hence it affects the capital structure.
 7. Availability of Funds :The availability of money in the capital and money market
will directly influence the company at the time of issuing securities Free flow of
money in the economy encourages a company to raise funds through securities
without much difficulty Hence a finance manager has to study the flow and
availability of funds before he decides about the capital structure.

8. Taxation Policy: High corporate tax may be encouraged to use more debt in its
capital structure as it can reduce the tax liability by deducting interest on debt out
of profits.

Meaning of Leverage

Leverage means the influence of one financial variable over some other related
financial variable.

Types of leverages

1. Operating leverage: Operating leverage means the ability of a concern to use

fixed operating costs to magnify the effect of change in sales on it operating
profits.

Operating leverage = C/EBIT

2. Financial leverage: Financial leverage indicates the percentage change in

earning per share in relation to percentage change in earnings before interest and
taxes (EBIT)

Financial leverage = EBIT/EBT

3. Combined leverage: Combined leverage is the combination of operating

leverage and financial leverage

Combined leverage = OL X FL
 Master table to calculate the leverages

Particular Amount
Sales xxx
Less : variable cost xxx
Contribution (c) Xxx
Less : Fixed cost xxx
EBIT/Operating Profit Xxx
Less : Interest (Debenture / long term loans ) xxx
EBT Xxx
Less : Tax xxx
EAT Xxx
Less : Preference dividend (preference share capital) xxx
EAESH (Earning Available For ESH) XXX

Num of Equity shares Xxx

EPS Xxx
X
Price earnings ratio (P/E Ratio) xxx
MPS XXX

EPS = EAESH/ Num of equity shares

Leverages

1. Operating Leverages = C /EBIT

2. Financial Leverages = EBIT/EBT
3. Combined Leverages = OL X FL