Capital structure refers to a combination of debt and equity that a company utilises to purchase assets and finance overall operations. Organisations can fund their activities via equity financing, debt financing, vendor financing and preference share capital.
The composition of debt and equity in the capital structure of a company represents its financial position and risk profile. Moreover, the mix of debt and equity determines the compatibility with certain investments and acquisition strategies. Once individuals understand the meaning of capital structure, they must learn about the components of capital structure in detail.
Components of Capital Structure
A company’s capital structure comprises multiple sources of funds that play a vital role in maximising shareholders’ wealth while minimising the cost of capital at the same time. The various sources that companies take into consideration are as follows:
1. Shareholders’ Funds (Owner’s capital)
Shareholders’ funds refer to funds that are contributed by the owners of a company. Such funds are raised via the issue of shares. It also involves the utilisation of retained earnings to finance business-related expenses. The following are the constituents of shareholders’ funds:
- Equity Share Capital: This refers to equity shares that provide the shareholders with ownership rights. Equity shareholders bear the highest risk; they are the actual owners of a company. The equity shareholders receive dividends for their investment in the company. That said, the rate of dividend is not fixed.
- Preference Share Capital: With regard to capital repayment and pay-out of dividends, preference shareholders enjoy preferential rights over investors owning equity shares. That said, preference shareholders do not enjoy voting rights. There are different types of preference shares, such as redeemable preference shares, convertible preference shares, and more. Note that the rate of dividend is fixed for preference shareholders.
- Retained Earnings: Retained earnings refer to a certain portion of the profit that the company doesn’t pay out dividends to its shareholders. Instead, it is reinvested in the business. This is also known as ploughing back of profits; a company can utilise the reinvested amount to facilitate further growth and expansion.
- Reserves and Surplus: Reserves and surplus refer to the accumulated profits that companies record as a portion of shareholders’ funds. This amount is earmarked for certain purposes, such as purchasing fixed assets, paying dividends, debt repayment, etc.
2. Borrowed Funds (Debt Capital)
Debt capital refers to funds that businesses raise from external sources and repay at a future date. Companies need to pay interest periodically on the borrowed funds, which can become burdensome if the debt is not managed efficiently. That said, the interest a company pays during a financial year is tax-deductible as per the Income Tax Act, 1961. Let’s take a look at the different types of borrowed funds.
- Term Loans: Term loans are funds that businesses raise from financial institutions such as banks, NBFCs at floating or fixed interest rates. Companies have to repay such loans in instalments. Such loans may or may not involve collateral. If a business has a strong financial position, acquiring funds from a financial institution is straightforward.
- Debentures: Debentures are debt instruments or fixed-income securities that companies issue to raise funds from the public. These financial securities have no collateral backing; they come with a high-interest rate. Before investing in debentures, individuals must assess the repayment capacity of the issuer.
Other fixed income instruments that companies may issue to raise funds include bonds, commercial bills, etc.
Factors Affecting Capital Structure Decisions
The aspects that influence capital structure decisions are as follows:
Nature of Business
The capital structure of a company is significantly influenced by the nature of the business. Companies having a stable income level go for term loans and debentures. Whereas businesses that don’t have an assured income usually opt for internal sources of finance as repaying the borrowed amount can be challenging.
Additionally, the lifecycle of a business influences decisions related to capital structure. With time, the cash consumers transform into cash generators; while business risk decreases, debt capacity increases.
Cost of Capital
Cost of capital refers to the cost incurred for raising funds from different sources. When deciding the debt-equity mix, managers prefer opting for sources that are associated with low costs. This can potentially maximise shareholder value.
Requirement of Investors
Businesses should take into account the investors’ requirements when making capital structure decisions. Different investors have distinct psychology which influences their investment decisions.
Size of Company
A company’s size has a lot of influence on the proportion of debt and equity in the capital structure. Large companies are more dependable owing to their financial prowess. Accordingly, they can easily raise additional funds via loans and the issue of debentures. On the flip side, small-sized companies find it difficult to raise debt capital. Hence, such companies rely more on equity financing than debt financing.
Extent of Control
Promoters of a company take decisions related to the capital structure based on how much control they want to have. If they want to have a high degree of control, they’ll prefer debt financing to equity financing as they won’t have to give up equity to raise additional funds.
Government Policies
The capital structure of a business is also impacted due to the policies and rules of the government. Any significant change in the fiscal or monetary policy can directly influence equity and debt composition in the capital structure.
Tax Rates
Besides the other aspects mentioned above, tax rates play a crucial role regarding capital structure decisions. If corporate tax rates are high, companies tend to opt for debt capital more than equity financing as the interest that a company pays on debt can be claimed as a deduction while calculating tax liabilities for a financial year. Dividends that a company pays out on equity and preference share capital are not eligible for a tax deduction.
After knowing the meaning of capital structure and understanding how it is influenced by several factors, individuals must become familiar with the importance of this concept.
Importance of Capital Structure
Let’s check out some of the reasons why it is essential for a business to have a prudent mix of debt and equity:
Mitigates Financial Risk
All businesses try to minimise the financial risk that is associated with their operations. If managers employ a balanced proportion of equity and debt in their capital structure, it will lead to risk mitigation.
Optimum Utilisation of Resources
A prudent capital structure ensures optimum utilisation of the available funds. Before opting for equity or debt financing, it is vital for businesses to determine the extent of their financial requirements. Only after assessing the needs, businesses should raise funds to ensure maximum efficiency.
Return Maximisation
The capital structure of a company has a vital role in maximising the total returns. If a company manages the proportion of debt and equity efficiently, its earnings per share (EPS) increases while the cost of capital reduces. This, in turn, maximises the total returns of shareholders.
Increases a Company’s Value
All investors prefer investing in companies having an ideal capital structure. A sound capital structure facilitates growth and expansion of operations, which positively impacts a company’s share price. This leads to an increase in the enterprise value and attracts more investors.
Tax Planning
The capital structure serves as a useful tax planning tool as the composition of the capital structure impacts the tax liability of a business. Companies can claim tax deductions on the interest paid towards debentures and bonds. This enables them to save taxes and record a higher net profit.
Optimal Capital Structure
An optimal capital structure is an ideal mix of equity and debt financing that leads to the maximisation of a company’s market value and simultaneously reduces the cost of capital. The cap structure varies for companies across different sectors. For instance, a company engaged in mining or oil extraction usually has low debt. On the other hand, insurance companies and banks operate with higher debt in their capital structure.
The capital structure of a company is measured using the debt-equity ratio. This ratio computes the overall value of financial liabilities and the total debt against the total equity share capital.
Typically, the D/E ratio is plotted on a trend line, which shows how it changes over a period of time. A company’s debt-equity ratio can be compared to the same ratio of a different company in the same sector to find out whether the company’s debt capital is unusually high.
Final Word
All companies try to achieve an optimal capital structure that can result in a lower cost of capital and higher shareholder value. That said, employing a prudent mix of debt and equity is not an easy task. It requires strategic thinking and an analytical approach. Companies have to identify a prudent mix of equity and debt that reduces their weighted average cost of capital (WACC) while maximising the market value.