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INTERNAL FACTORS DETERMINING CAPITAL STRUCTURE
The following internal factors must be considered while determining the
capital structure of a company:-
1. Nature of Business: The capital structure of a company is considerably
affected by the nature of its business. Public utilities, extractive, financing, and merchandising enterprises are more stable in their earnings and enjoy a greater degree of freedom from competition than industrial concerns. Thus,
companies having stable earnings can
afford to raise funds through sources involving fixed charges, while other
companies have to rely heavily on equity share capital.
2. Regularity and Certainty of Income: Capital structure is
also affected by the regularity and certainty of income. If the company expects
sufficient regular income but it is hopeful that its average earnings for a few years may be equal to or in excess of the amount of dividend to be
paid on such preference shares. If a company does not expect any regular income
in the future, it should never issue any type of securities other than equity
shares.
3. Desire to Control
the Business: The shareholder’s or
promotors' desire to control the affairs of the company directly affects its
capital structure. If the control of the company is to be retained within a few
hands, a large proportion of funds is raised by the issuance of non-voting rights
securities, such as debentures and preference shares.
4. Future Plans: The capital structure of a company is also affected
by its development and expansion programs in the future. For this purpose, the
amount of authorized capital is kept higher so that the requisite amount may be
raised at the time of need. At the outset, the company collects capital by
issuing equity shares. Thereafter, capital structure is devised in accordance
with the future development and expansion programs and the requisite capital
is raised by issuing preference shares and debentures.
5. Purpose of Finance: An important factor determining the
type of capital to be raised is the purpose for which capital is required. If funds are needed for some productive activity that will directly add
to the profitability of the company, capital may be raised by issuing securities bearing fixed charges
like preference shares and debentures. Conversely, if funds are needed for such
purposes as betterment, maintenance, etc., which do not directly add to the
earnings of the company, retained earnings or equity share capital will be the better source of financing.
6. Attitude of Management: The capital structure of a company is
also affected by the attitude of the management. Management varies to skill,
judgment, experience, temperament, and motivation. It evaluates the same risks
differently and its willingness to employ debt capital also differs. The
influence of capital structure is, therefore, equal to the age, experience,
ambition, confidence, and conservativeness of the management.
7. Trading on Equity: Trading on equity refers to the regular
use of borrowed capital as well as equity capital in the conduct of a company's
business. In other words, when a company employs borrowed capital including
preference share capital in such a way as to increase the rate of return on
equity shares, it is said to be trading on equity. Obviously, if the fixed rate
of interest on borrowed capital or dividend on preference shares is lower than
the general rate of earnings of the
company, the equity shareholders will have an advantage in the form of an additional dividend. Trading on equity, therefore, implies the presence of favorable financial leverage in the company's capital structure. Thus, a company would prefer to issue debentures
or preference shares having a rate of interest or dividend lower than the
general rate of its earnings.
8. Debt Capacity and Extent of Risk: The use of borrowed capital becomes risky for the company after a certain extent because it would lead to an increase in the fixed liability of interest payment adversely affecting the company's income and reducing its liquidity. In the long-run, excessive use of borrowed funds also endanger the solvency of the company. A high debt-equity ratio is risky for companies with uncertain, irregular, and inadequate earnings. So, the determination of the debt-equity ratio of such companies should be in accordance with their debt capacity.
9. Cost of Capital: Cost of capital is an important
determinant of the capital structure of a company. Since cost of capital directly
influences the profitability and general rate of earnings, a company must
select such sources of finance as would entail the incurrence of the least
cost. Generally, a company must raise capital funds by borrowings when the rate of
interest is low and by issuing equity shares when the rate of earnings and share
prices are high.
10. Capital Gearing Ratio: Equity shares are the foundation of the capital of a company. The ratio of fixed cost-bearing capital to variable cost-bearing capital is called 'capital gearing'. When the ratio of equity shares (i.e., variable cost-bearing capital) is low in the total capital structure, it is called 'High Gearing'. Conversely, when the ratio of equity shares in the total capital structure of a company is high, it is called 'Low Gearing'. Stability in equity share price and goodwill of a company depends on adequate capital gearing. A high capital gearing ratio encourages speculation in shares of such a company and the market price of shares continues to fluctuate. It is, therefore, necessary for the promotors to determine the ratio of fixed-cost securities (preference shares and debentures) and fluctuating-cost securities (equity shares) very carefully.
11. Timing and Duration of Finance: If capital funds are
needed for the short term, they must be arranged through borrowings. Funds raised
by issuing fixed-cost securities (debentures and redeemable preference shares)
can be repaid as soon as the company's financial position becomes strong. On the
other hand, long-term capital funds must be raised by issuing equity shares.
12. Flexibility and Simplicity: The capital structure must
be flexible to increase or decrease the funds as per the requirements of the
enterprise. Excessive dependence on
fixed-cost securities makes the capital structure rigid because of the fixed payment
of interest of dividends. Thus, these sources should be kept in reserve for
emergency and expansion purposes. The capital structure must also be simple, so
that financial crisis may be avoided.
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