Capital structure signifies the composition of the amount of long-term financing and according to Gerstenberg, “Capital structure means the types of securities to be issued and the proportionate amounts that makeup capitalization”. Long term finds can be obtained from owners and borrowers. The owner’s fund consists of equity shares, preference shares, and retained earnings. Borrower’s fund (debt capital) includes debentures and other long term borrowings and the ratio between the owner’s fund (equity) and borrower’s fund is decided under the capital structure.
DETERMINANTS OF CAPITAL STRUCTURE
As stated earlier capital structure decision is highly individualistic and the capital structure of a company is planned initially when the company is floated. The initial capital structure must be designed very carefully since it will have long-term implications. However, the capital structure decision is a continuous one and has to be taken every time whenever a firm needs additional finances. Several factors affect the capital structure of a firm. Some of the important factors which must be kept in mind while determining the capital structure are discussed as follows:
1. Cash flow position
While choosing if capital structure the future cash flow position must be considered before issuing debt. Cash flow must not only cover fixed cash payment obligations but there must be sufficient buffer also, it must be kept in mind that a company has cash payments obligations for (i) Normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e. payment of interest and repayment of principal.
2. Interest Coverage Ratio
By the use of this ratio, it can ascertain whether the company can pay interest or not. The greater this ratio, the more will be the capacity of the company to use debt. The ratio can be calculated as under:
Interest coverage ratio= Earnings before interest & Taxes/ Interest
3. Debt Service coverage ratio- DSCR:
The debt service coverage ratio takes care of the weaknesses referred to in the interest coverage ratio-ICR. A higher DSCR indicated better ability to meet cash commitments and consequently, the company’s potential to increase debt components in its capital structure.
4.Cost of Debt
The capacity of a company to take depends on the cost of debt. In case the firm arranges borrowed funds at a low rate of interest then it will prefer more debt as compared to equity and vice versa.
5. Tax rate
High tax rate makes debt cheaper as the interest paid to debt security holder is subtracted from income before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high-end tax rate means prefer debt whereas at low rate tax the company can prefer equity in the capital structure.
6. Cost of equity capital
The cost of a source of finance is the minimum rate of return expected by its Suppliers. Equity shareholders bear the maximum risk because no rate of dividend is fixed. To pay interest on debentures is a statutory liability of the company whether the company earns a profit or not. Thus, debt is cheaper as compared to ordinary share capital. The cost of debt becomes lesser because interest is a charge on the taxable income.