Change in Capital Structure
The term structure can be explained as an arrangement of many parts. Hence, capital structure is referred to as a capital method from different sources so that long-term funds required in business are raised.
Thus, the capital structure looks at the permutations or combinations of debentures, equity share capital, preference share capital, retained earnings, long-term loans, and other sources of long term funds in the total amount of capital needed by a business to make it function.
The capital structure in a firm is generally expressed as debt to equity or debt to capital ratio. The total amount of debt or equity employed by a firm to fund the operations and finance the assets in a business.
To fund the business’s operations, acquisition, and other investments, organizations use debt and equity capital. Companies need to look at tradeoffs and then decide whether they need to use the debit or equity to finance the operations. The managers balance the two to check the optimal capital structure.
Equity comes in the form of common stock, retained earnings, or preferred stock. Short-term debt is also deemed as a part of the capital structure.
What is Capital Structure, Financial Structure, and Assets Structure?
The term capital structure is different from the financial structure and assets structure. In comparison, the financial structure consists of long-term debt, short-term debt, and shareholder's fund, i.e., the complete left-hand side of the company’s balance sheet. However, the capital structure includes long term debt and the shareholders’ fund.
Hence, it can be concluded that the capital structure in an organization is a part of its financial structure. Some professionals of financial management include short-term debt in the formation of a capital structure. In this type of case, there is no difference between the two terms capital structure and financial structure.
Hence, capital structure is different from the financial structure. It is a portion of the financial structure. The capital structure includes the proportion of long-term debt and equity in the total capital of the business. On the contrary, financial structure refers to the net worth or owners' equity and all liabilities (including both the long term and short-term).
The capital structure does not include short-term liabilities, whereas financial structure includes short-term liabilities or current liabilities.
The assets structure signifies the composition of total assets used by an organization. It specifies the application of funds in the various types of assets fixed as well as current.
- Assets structure = Fixed Assets + Current Assets.
- The term capitalization refers to the total amount of long-term funds at the disposal of the company. It did not matter how it was raised. It can be raised from equity shares, preference shares, retained earnings, debentures, or institutional loans.
What is the Importance of Capital Structure?
The importance of capital structure is as follows:
Increase in the value of the firm
A proper capital structure of a company helps in increasing the market price of the shares and securities that, in turn, will lead to an increase in the value of the company.
Utilizing the available funds
An organized capital structure permits a business to utilize the available funds completely. An appropriately planned capital structure guarantees the assurance of the money related necessities of the firm and raises the assets in such extents from different hotspots for their most ideal use. A sound capital structure shields the business venture from over-capitalization and under-capitalization.
Maximization of return
A sound capital structure empowers the board to expand the benefits of an organization as better yield to the value investors, i.e., increment in income per share. This should be possible by the system of exchanging on value, i.e., it alludes to increment in the extent of obligation capital in the capital structure, which is the least expensive wellspring of capital. In the event that the pace of profit for capital utilized surpasses the fixed pace of premium paid to obligation holders, the organization is supposed to exchange on value.
Minimizing the cost of capital
A sound capital structure of any business undertaking expands investors' riches through the minimization of the usual expense of capital. This must likewise be possible by joining long term debt capital in the capital structure as the expense of debt capital is lower than the expense of value or inclination share capital since the enthusiasm on the obligation is charge deductible.
Solvency or Liquidity position
A proper capital structure will never allow a business to go for too much raising of debt capital because, during the time of poor earning, the solvency is disturbed for mandatory payment of interest to the supplier of debt.
A proper capital structure gives room for expansion or reduction of the debt capital so that, as per the changing conditions, the adjustment of capital can be made.
A better capital structure does not permit the equity shareholders' control on business that is to be diluted.
Minimization of financial risk
In the event that obligation part increments in the capital structure of an organization, the budgetary hazard will likewise increment. A sound capital structure shields a business endeavour from such monetary hazard through a wise blend of obligation and value in the capital structure.
What are the Factors that Determine the Capital Structure?
The factor that influences capital structure decisions are as follows:
Risk of cash insolvency
The risk related to cash insolvency arises due to the failure in paying the fixed interests in liabilities. Usually, the higher proportion of the debt in the capital structure compels the firm to pay a higher rate of interest on the debt, irrespective of the fact whether the fund is available or not. The non-payment of the charges in interest and the principal amount in time invites the liquidation of the company.
The abrupt withdrawal of debt funds from the organization can cause cash insolvency. In the determination of capital structure, the risk factor of a company has an important bearing, and it can be avoided if the project was financed by the issues of equity share capital.
Risk in the variation of earnings
The higher the obligation contained in the capital structure of an organization, the higher will be the danger of variety in the normal income accessible to value investors. On the off chance that arrival on venture on absolute capital utilized (i.e., investors' reserve in addition to long term debt) surpasses the loan cost, the investors get a better yield.
Then again, if loan cost surpasses the degree of profitability, the investors may not get any arrival whatsoever.
Cost of capital
The cost of capital refers to the cost of raising capital from various different sources of funds. It is the price paid for utilizing the capital. A business must generate sufficient revenue to fulfil its cost of capital and then finance the growth in the future. The finance manager must consider the cost of all sources of funds while designing the capital structure of a business.
The thought of holding control of the business is a significant factor in capital structure choices. On the off chance that the current value investors don't care to weaken the control, they may incline toward obligation money to value capital, as previously has no democratic rights.
Trading on equity
The utilization of fixed enthusiasm bearing protections alongside proprietor's value as wellsprings of the fund is known as exchanging on value. It is a course of action by which the organization targets expanding the arrival on value shares by the utilization of fixed enthusiasm bearing protections (i.e., debenture, inclination shares, and so on).
On the off chance that the current capital structure of the organization comprises predominantly of the value shares, the arrival on value offers can be expanded by utilizing acquired capital. This is so on the grounds that the intrigue paid on debentures is a deductible use for personal expense evaluation, and the after-charge cost of debenture turns out to be extremely low.
Any abundance of income over the expense of obligation will be signified the value investors. In the event that the pace of profit for complete capital utilized surpasses the pace of enthusiasm on obligation capital or pace of profit on inclination share capital, the organization is supposed to exchange on value.
Capital structure is usually influenced by Government policies, rules, and regulations of SEBI and the lending policies of financial institutions that change the financial pattern of the company completely. The government's monetary policy and the fiscal policy also affect the decisions related to capital structure.
Size of the company
The size of the company influences the availability of funds. It is difficult for a small company to raise debt capital. The terms of long-term loans and debentures are less favorable for businesses. Small companies depend more on equity shares and retained earnings.
On the contrary, large companies issue different types of securities despite the fact that they have to pay less interest because the investors consider large companies less risky.
Needs of the investors
While choosing a capital structure, the money related conditions and brain science of various sorts of financial specialists should be remembered. For instance, a poor or working-class speculator may just have the option to put resources into value or inclination shares, which are for the most part of little groups, just a monetarily stable financial specialist can bear to put resources into debentures of higher divisions.
A mindful financial specialist who needs his money to develop will lean toward equity shares.
The capital structures of an organization ought to be with the end goal that it can raise assets as and when required. Adaptability gives space to development, both as far as lower sway on cost and with no noteworthy ascent in chance profile.
Period of finance
The period for which account is required likewise impacts the capital structure. At the point when assets are required for long term debt (say ten years), it ought to be raised by giving debentures or preference shares. Assets ought to be raised by the issue of equity shares when it is required permanently.
Nature of business
It has an extraordinary impact on the capital structure of the business, organizations having steady and certain profit lean toward debentures or preference offers, and organizations having no guaranteed pay rely upon inward assets.
The finance manager must comply with the legal provisions while designing the capital structure of a company.
Purpose of financing
The capital structure of an organization is likewise influenced by the motivation behind the financing. On the off chance that the assets are required for assembling purposes, the organization may secure it from the issue of long haul sources. At the point when the assets are required for non-fabricating purposes, i.e., government assistance offices to labourers, similar to a class, clinic, and so on, the organization may acquire it from inward sources.
At the point when corporate pay is liable to charges, obligation financing is good. This is made in light of the fact that the profit payable on value share capital and inclination share capital are not deductible for charge purposes, while intrigue paid on the obligation is deductible from pay and lessens an association's duty liabilities. The expense of saving money on premium charges decreases the expense of obligation reserves.
Besides, an organization needs to pay a charge on the sum conveyed as profit to the value investors. Because of this, complete income accessible for both obligation holders and investors is more when obligation capital is utilized in the capital structure. Along these lines, if the corporate assessment rate is sufficiently high, it is judicious to raise capital by giving debentures or taking long term debt advances from money related organizations.
The capacity of the business also affects the selection of capital structure in business for the purpose of generating cash flows. It also analyses the solvency position and the capability of the companies to meet its charges.
Provision for future
The provision related to the future requirement of capital must also be considered amidst the planning of the capital structure of a business enterprise.