Capital Structure Decisions and Maximization of Shareholders Wealth
“The Capital Structure Decision of the firm is affected by various internal and external factors. The major factors include nature and size of the firm, cost of specific sources of capital, growth, and stability of earning, an attitude of management, legal rules, the period of finance, lenders attitude, corporate tax rate, desire of control, business risk of firm, best practices in the industries, etc.”
Capital structure decision is considered as one of the most important decisions of the firm. This decision is primarily concerned with the determination of a proportionate mix of long-term sources of capital. The capital structure decision taken by the firm has an influence on the firm’s cost of capital, risk position and value of the firm. The use of a composition of these long-term sources of financing effect on both the return and risk of shareholders.
Generally, firms employ debt in its capital structure with the view to increase the return of common stockholder. However such increased return is achieved at the increased risk. Thus, capital structure effects on both return and risk of stockholders. The appropriate mix of a long-term source of financing helps to increase the market price of a stock and thus increase the wealth of stockholders.
Overview of Principles of Capital Structure Management
While planning a capital structure decision, the following principles are to be followed:
Cost Principle: According to this standard, a perfect capital structure ought to limit cost financing and boost procuring per share. Debt capital could be a cheaper sort of capital thanks to 2 reasons. First, the expectations of returns of debt capital holders are but those of equity shareholders. Secondly, interest is a deductible expense for tax purposes whereas dividend is an appropriation.
Risk Principle: According to this principle, an ideal capital structure should not accept unduly high risk. Debt capital is a dangerous type of capital as it includes legally binding commitments with regards to the installment of intrigue and reimbursement of chief aggregate independent of benefits or misfortunes of the business. If the organization issues a large number of preference shares, out of the earnings of the organization, less amount will be left out for equity shareholders as a dividend on inclination, offers is required to be paid before any profit is paid to value investors. Raising the capital through equity shares involves the least risk as there is no obligation as to the payment of dividend.
Control Principle: According to this principle, the ideal capital structure should keep controlling the position of owners intact. As inclination investors and holders of obligation capital convey constrained or no casting ballot rights, they scarcely irritate the controlling position of leftover proprietors. Issue of value offers aggravates the controlling position straightforwardly as the control of the lingering proprietors is probably going to get weakened.
- Flexibility Principle: According to this principle, the ideal capital structure should be able to cater to additional requirements of funds in the future, if any. e.g. if a company has already raised too heavy debt capital, by mortgaging all the assets, it will be difficult for it go further loans in spite of good market conditions for obligation capital and it should rely upon value shares just for raising further capital. Moreover, an organization should avoid capital on such terms and conditions which limit a company’s ability to procure additional funds. If the company accepts debt capital on the condition that it will not accept further loan capital or dividend on equity shares will not be paid beyond a certain limit, then it loses flexibility.
- Timing Principle: As per this rule, the perfect capital structure ought to have the option to take advantage of market lucky breaks, ought to limit the expense of raising assets and get considerable investment funds. Accordingly, during the day of boom and prosperity, a company can issue equity shares to get the benefit of an investor’s desire to invest and take the risk. During the times of wretchedness, obligation capital might be utilized to raise the capital as the speculators are hesitant to go for broke.
Factors Affecting Capital Structure
The capital structure decision of the firm is affected by various internal and external factors. Some are related to the specific firms while other factors are generic and common to all irrespective of their size, ownership structure, nature of the business, etc. Therefore, it is necessary to consider these factors are while taking the capital structure decision. The major factors affecting the capital structure decision are explained hereunder.
- Characteristics of Firm: Characteristics of the firm in terms of size, age, and credit standing play a very important role in deciding capital structure. Extremely little organizations and the organizations in their beginning times of the need to depend more on the value capital, as they have restricted dealing limit, they can’t tap various sources of raising the funds and they do not enjoy the confidences of the investors.
Likewise, the organizations having great credit remaining in the market might be in the situation to get their preferred assets from the wellsprings however this decision may not be accessible to the organizations having a poor credit standing.
You May Like:
- Stability of Earnings: If the sale and earnings of the company are not likely to be stable enough over a period of time, the risk factor assumes a progressively significant job and the organization will most likely be unable to have more acquired capital in its capital structure as it conveys more risk. In any case, if the income and offers of the organization are genuinely steady and stable over the timeframe, it might stand to go out on a risk, where the cost factor or control factor may assume a significant job.
- Component Cost of Capital: Various sources of capital involves cost. There exist differences across the sources of capital in terms of cost involvement. The optimal capital structure should be less costly. Therefore, while planning capital structure decisions, cost of various sources of capital is to be considered. Generally, the cost of debt is lower than other sources of financing. Hence, financial managers tend to use more debt capital in the capital structure.
- The attitude of the Management: Management attitude has a paramount role in capital structure decision. Management attitude may range from conservative to aggressive. Some management tends to be more conservative than others and uses less debt than average firms in their industry. On the other hand, aggressive management tends to use more debt in the capital structure to earn a higher return. Therefore, understanding of the attitude of management is the must before taking capital structure decision. Planning of capital structure decision must be in line with an attitude of management towards risks.
- Control Factor: While arranging the capital structure and all the more especially while raising extra assets, the control factor assumes a significant job, particularly on account of firmly held private restricted organizations. On the off chance that the organization chooses to raise the long-term funds by issuing further value offers or inclination shares, it weakens the controlling enthusiasm of the present investors/proprietors, as the value investor appreciates total casting ballot rights and inclination investors appreciate constrained casting ballot rights. The control factor ordinarily does not come into the image if there should be an occurrence of obtained capital except if the loan specialist of the long-term funds., i.e. banks or financial institutions, stipulate the appointment of nominee directors on the board of directors of the company.
- Objects of Capital Structure Planning: While planning the capital structure, the following objects of the capital structure planning come into play:
->To maximize the profits of the owners of the company. This can be ensured by issuing the securities carrying less cost of capital.
->To issue the securities which are easily transferable? This can be ensured by listing the securities on the stock exchange.
-> To issue further securities in such a way that the value of shareholding of the present owners is not affected.
The objectives of capital structure planning should be clearly defined before taking the capital structure decision.
- Level of Internet Rates: In the event that assets are accessible in the capital market just at the higher rates of the premium, the bringing of capital up in the type of acquired capital might be deferred till the interest rates become great.
- General Economic Conditions: While arranging the capital structure, the general monetary conditions ought to be considered. If the economy is in the state of depression, interference will be given to equity form of capital as it will be involving less amount of risk. But it may not be possible always as the investors may not be willing to take the risk. Under such circumstances, the company may be required to go in borrowed capital. If the capital market is in boom and interest rates are likely to decline in further, equity from the capital to be tapped in the future. It may also be possible to raise more equity capital in the boom as the investors may be ready to take the risk and to visit.
- The policy of Lending Institutions: If the policy of lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital, but the equity capital form should be tapped.
- Taxation Policy: Tax collection approach of the administration must be seen from the points of both corporate tax assessment and just as an individual tax assessment. As far as individual taxation is concerned, both interest, as well as a dividend, will be taxable in the hands of lender of the capital subject to specified deductions available for the purpose.
- Statutory Restrictions
- Timing Of Finance
- Asset Structure
- Market Condition