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Determinants of Capital Structure

Prerequisites

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1. Introduction

Capital structure decisions are influenced by multiple factors. There is no universal formula - each company must consider its unique circumstances.

2. Major Determinants

2.1 Cost Consideration

Principle: Choose sources that minimize WACC.

  • Debt is cheaper due to tax shield (interest deductible)
  • But excessive debt increases risk, raising cost of equity
  • Balance needed

Example: If Kd (after-tax) = 7% and Ke = 16%, more debt initially reduces WACC, but beyond a point, risk increases Ke significantly.

2.2 Risk Consideration

Business Risk:

  • High business risk firms → Use less debt (avoid adding financial risk)
  • Stable industries (FMCG, utilities) → Can afford more debt

Financial Risk:

  • Debt creates fixed obligations
  • Inability to pay → Bankruptcy
  • High debt = High financial risk

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2.3 Control Considerations

Debt Financing:

  • No voting rights to lenders
  • Existing shareholders retain control
  • Preferred when promoters want to maintain control

Equity Financing:

  • New shareholders get voting rights
  • Dilutes existing control
  • May lead to hostile takeover risk

Example: A family-owned business wanting to retain control prefers debt over equity.

2.4 Flexibility and Future Financing

Debt Capacity:

  • Every firm has a borrowing limit
  • Excessive current debt → Difficult to borrow in future
  • Need to maintain reserve borrowing capacity

Trading on Equity:

  • Keeping debt option open for future opportunities
  • Important for growing companies

2.5 Cash Flow Ability

Principle: Debt requires fixed cash outflows (interest + principal).

  • Companies with strong, stable cash flows → Can handle more debt
  • Erratic cash flows → Prefer equity (dividend discretionary)

Evaluation:

Cash Flow Coverage Ratio = Operating Cash Flow / Debt Service

Ratio > 2 is generally safe

2.6 Profitability and Return

Trading on Equity (Financial Leverage):

  • If Return on Investment (ROI) > Cost of Debt (Kd), use debt
  • Amplifies returns to equity holders

Example:

Total Capital Needed: ₹100 lakhs
Project ROI: 20%
Cost of Debt: 10%

Scenario 1: 100% Equity
Return to equity = 20% of ₹100L = ₹20L (20% on equity)

Scenario 2: 50% Debt + 50% Equity
Total Return = 20% of ₹100L = ₹20L
Less: Interest on ₹50L debt = 10% of ₹50L = ₹5L
Return to ₹50L equity = ₹15L (30% on equity!)

With debt, equity holders earn 30% instead of 20%!

2.7 Nature and Size of the Firm

Large, Established Firms:

  • Better credit rating
  • Can raise debt easily and at lower cost
  • More access to capital markets

Small, New Firms:

  • Limited credit history
  • Higher perceived risk
  • Difficult to raise debt → Rely on equity/retained earnings

2.8 Tax Considerations

Interest Tax Shield:

  • Interest on debt is tax-deductible
  • Higher tax rate → More benefit from debt

Formula:

Tax Shield = Interest × Tax Rate

Example:

Interest = ₹10,00,000
Tax Rate = 30%
Tax Shield = ₹10,00,000 × 0.30 = ₹3,00,000 saved

Companies in high tax brackets benefit more from debt.

2.9 Asset Structure

Tangible Assets (Land, Building, Machinery):

  • Can be offered as collateral
  • Easy to raise secured debt

Intangible Assets (Software, Goodwill):

  • Difficult to pledge
  • Must rely more on equity

Example: Manufacturing company (heavy assets) vs IT company (few tangible assets)

2.10 Market Conditions

Bull Market (Rising Stock Prices):

  • Good time to issue equity (get high price)
  • Equity financing attractive

Bear Market (Falling Prices):

  • Poor time for equity issue (low valuation)
  • Prefer debt or wait

Interest Rate Environment:

  • Low interest rates → Favor debt financing
  • High rates → Prefer equity or wait

Summary Table of Determinants

FactorFavors DebtFavors Equity
Business RiskLow risk industryHigh risk industry
ProfitabilityHigh ROI > KdLow ROI
ControlWant to retain controlDon't mind dilution
Tax RateHigh tax rateLow/zero tax
AssetsTangible, pledge-ableIntangible
Firm SizeLarge, establishedSmall, new
Cash FlowStable, strongErratic, weak
Market ConditionsBear market, low ratesBull market

Exam Pattern Questions and Answers

Question 1: "Explain any SIX determinants of capital structure." (12 Marks - 2 marks each)

Answer:

  1. Cost of Capital: Companies choose a capital mix that minimizes weighted average cost of capital (WACC). Debt is generally cheaper due to tax shield on interest, but excessive debt increases risk premium on equity, raising overall cost.

  2. Risk: Firms with high business risk (volatile earnings) prefer less debt to avoid compounding risk with financial leverage. Stable firms can afford higher debt as they can reliably service fixed obligations.

  3. Control: Debt doesn't dilute ownership as lenders have no voting rights. Companies wanting to retain control prefer debt financing. Equity issuance brings new shareholders who share control.

  4. Profitability: Highly profitable firms with returns exceeding debt cost benefit from "trading on equity" - using debt to magnify returns to shareholders. Low profitability firms avoid debt's fixed burden.

  5. Asset Structure: Firms with substantial tangible assets (land, machinery) can easily raise secured debt by pledging assets. Service firms with few tangible assets must rely more on equity.

  6. Tax Rate: Interest on debt is tax-deductible, creating a tax shield. Higher the firm's tax rate, greater the benefit from debt financing, making it an attractive choice for companies in high tax brackets.

Question 2: "Why do companies with high business risk prefer equity to debt?" (4 Marks)

Answer: Companies with high business risk experience volatile and unpredictable earnings due to factors like uncertain demand, intense competition, or rapid technological change. Such firms prefer equity over debt for two main reasons:

  1. Avoiding Fixed Obligations: Debt creates mandatory interest and principal payments regardless of profits. With uncertain earnings, high-risk firms may struggle to meet these fixed commitments, risking bankruptcy. Equity dividends are discretionary - can be skipped in bad years.

  2. Preventing Risk Compounding: High business risk already makes the firm risky for investors. Adding financial risk through debt would compound the total risk excessively, making it very difficult and expensive to raise any financing. Using equity keeps financial risk low, compensating for high business risk.

Summary

No Single Formula: Capital structure depends on multiple interacting factors.

Key Determinants:

  1. Cost (minimize WACC)
  2. Risk (business + financial)
  3. Control (dilution concern)
  4. Cash Flow (ability to service debt)
  5. Profitability (ROI vs Kd)
  6. Size (access to markets)
  7. Taxes (interest shield)
  8. Assets (collateral availability)
  9. Market Conditions
  10. Flexibility

Decision is Balancing Act: Trade-offs between cost, risk, and control.

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Quiz Time! 🎯

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