Capital Structure is the ratio of different types of securities raised by a firm as its long-term finance. Capital structure decision involves two philosophies −
Type of securities to be issued in capital structures must be equity shares, preference shares, and long-term borrowings (Debentures).
Relative ratio of the securities can be obtained by the process of capital gearing. On the basis of gearing, the companies are divided into two categories −
Highly geared companies – The companies which have a proportion of equity capitalization that is small.
Low geared companies – The companies the equity capital of which is high in relation to their total capitalization.
The following factors determine the capital structure of a company −
Degree of Control
The Flexibility of the Plan
The word "equity" here means the ownership of the firm. Trading on equity refers to taking advantage of equity share capital to borrow long-term funds on a reasonable basis.
It is the additional profit equity shareholders earn due to the issuance of debentures and preference shares.
It is based on the principle that when the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the usual rate of company’s earnings, equity shareholders are at an advantageous position, which means a company should go for issuance of preference shares, equity shares as well as debentures.
Trading on equity is more important when the expectations of shareholders are high.
In a company, the directors are the so-called elected representatives of equity shareholders. These members have the maximum voting rights in concerns as compared to the debenture holders and preference shareholders.
Preference shareholders usually have very little voting rights, while debenture holders have none.
If the company’s management policies are such that the power is retained at its management’s hands, then its capital structure will consist of debenture holders and loans instead of equity shares.
In an enterprise, there should be flexibility in plans. In other words, the capital structure should be such that there are both contractions and relaxation in plans.
Debentures and loans issued by the company can be refunded back as time requires.
As equity capital cannot be refunded, it offers rigidity to plans.
So, to make the capital structure possible, the company should issue debentures and other loans.
A company’s policy usually tends to have different types of investors for securities. Therefore, a capital structure should offer enough choice to all kinds of investors to invest.
Bold and risk-seeking investors generally go for equity shares.
Loans and debentures are generally raised keeping in mind the conscious investors.
In the lifetime of a firm, the market price of its shares usually gets an important influence.
During the depression period, the company’s capital structure usually consists of debentures and loans.
While in the period of booms and inflation, the company’s capital should consist of share capital that is generally constituted of equity shares.