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What Are The Factors Affecting Capital Structure Of A Company?

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In every business organization, capital is the main element to establish and run its business activities smoothly. Capital can be collected by using two sources. They are debt capital and equity capital. Debt capital is collected by issuing debentures; bonds etc and they are related with fixed cost of capital. Equity capital can be collected issuing different shares like common stock, preferred stock etc. In simple words, maintaining the balance or proportion of this capital is known as corporate capital structure. So it refers to the combination of various sorts of securities through which funds are raised.        Sometimes some financial experts define it as all those capitals and liabilities, which are included in balance sheet. But actually it is not a realistic approach. Capital is related only with long term fund. Hence,      Capital Structure = Financial Structure - Current Liabilities  Capital structure may be defined as the mixture of debt and equity that comprises the financing of its assets. Hence, the total balance of capital and liabilities is financial structure, not a capital structure. The main objective of financial manager behind capital structure management is to minimize the overall cost of capital and risk, and take the advantage of favorable financial leverage and corporate tax. So while maintaining the proportion between debt and equity, their merits and demerits should be evaluated relatively.  It is not possible to have an ideal capital structure, however, the management should target capital structure and initial capital structure should be framed with subsequent changes in initial capital structure to have it like target capital structure. Some companies do not plan capital structure but they are still achieving a good prosperity.  There are significant variations in the capital structures of different industries and different companies. There are many factors that affect capital structure. Following are the basic factors which should be kept in view while determining the capital structure.            1. Growth and stability of sales  Firms that are growing rapidly generally need larger amount of external capital. The floatation costs associated with debt are generally less than those for common stock, so rapidly growing firms tend to use more debt. At the same time, however, rapidly growing firms often face greater uncertainty which tends to reduce their willingness to use debt. Firms whose sales are relatively stable can use more debt and incur higher fixed charges than a company with unstable sales.        1. Competitive structure/ stability of profit margin.  Firms with high rate of return on investment use relatively little debt. Their high rate of return enables them to do most of their financing with retained earnings. If profit margin is constant more debt is used.      3. Cash flow ability  The selection of capital structure is also influenced by the capacity of the business to generate cash inflows, stability, and certainty of such inflows. Regularity of cash inflows is much more important than the average cash inflows. A company with unstable and unpredictable cash inflows can no longer afford to depend on debts.      4. Cost of capital  If the cost of capital is too high, borrowing is costly. So at that situation equity capital is preferable. As compared with other securities, the equity shares are more economical because they have least cost of capital. In the processing of trading, no more floatation costs, brokerage costs etc are incurred.      5. Control      The consideration of retaining "Control" is also very important. The ordinary shareholder can elect the directors of the company. If company sells the common stock, it will bring new voting investors into the firm, making the control difficult. To maintain control within the hand of limited members, a firm has to use more amount of debt or preferred stock because they have no management and voting right. If the firm wants to more equity shares the management right will be diversified.  6. Marketability or lender's attitude  The term 'Marketability' refers to the readiness of investors to purchase a security in a give n period of time. The capital markets keep changing continuously. The capital structure will have to be customized to the attitudes of investors prevailing at the time of issue of capital. If investors demand preference shares, firm must have issue of preference share capital. Due to the changing market sentiments, the company has to decide whether to raise funds with a common shares issue or with a debt issue.  7. Size of the company  The availability of funds is greatly influenced by the size of the enterprises. A small company finds it difficult to raise debt capital. The terms of debentures are less favorable to small companies so they have to rely on equity share and retain earning for funding business. Large companies are generally considered to be less risky by the investors and, thus, they can issue common shares, preference shares and debentures to the public.  8. Floatation cost  Floatation costs take place only when the funds are externally raised. Floatation costs consist of some or all of the following expenses; printing of prospectus, advertisement, underwriting and brokerage etc. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may lure the company to issue debt than common shares. The company will save in terms of floatation cost if it raises funds through large issue of securities but the company should raise only that much of funds which can be employed profitably. In large companies flotation cost is not a significant consideration.  9. Development of capital market  It's an important factor in capital structure. It refers to the extend which the capital market is developed (i.e. Equity or debt market). More developed equity market means more equity used and less developed equity means less equity used. Similarly, more developed debt market means more debt used and vice versa.      10. Growth opportunities  The growth opportunities of business can be either tremendous or very low. Depending upon the growth opportunities the debt ratio fluctuates. Higher growth opportunities exist then higher debt is used otherwise vice versa.      11. Agency costs  While determining capital structure, having least agency cost is preferred but if there is agency problem than debt is used largely for funding the business.      12. Other sources of tax shield  In order to take the advantage of low tax, borrowing is preferable for a firm because interest is considered as deductible expenditure according to the income tax law. But dividends are not considered deductible expenses and they are paid out of profits after tax.      13. Level of economic development  If the level of economic development is high then more debt is required. Level of economic development plays significant role in capital structure. In Nepal investors ar shifting to India. Since India is becoming economic giant, Nepali investors are also investing in Indian organization.

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