What Factors Determine Capital Structure? An appropriate capital structure can be determined by deciding the proportion of various types of securities (i.e., equity shares, preference shares, debentures) to be issued. This depends upon the following factors:

1.    Financial Leverage or Trading on Equity. The word ‘ equity’ denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to the additional profits that equity shares earn because of funds raised by issuing other form of securities, viz., preference shares and debentures. It is based on the premise that if the rate of interest on borrowed capital ad the rate of dividend on preference capital is lower than the general rate of company’s earnings, the equity shareholders will get advantage in the form of additional profits. An illustration of this has been given later in this chapter. Thus, by adopting a judicious mix of long-term loans (debentures) and preference shares with equity shares, return on equity shares can be maximized.

2.    Expected Cash Flows. Debentures and preference shares are often redeemable i.e., they are to be paid back after their maturity. The expected cash follow over the years must be sufficient to meet the interest liability on debentures every and also to return the maturity amount at the end of the term of debentures. Thus, debentures are not suitable for those companies which are likely to have irregular cash flows in future.

3.    Stability of Sales. Stability of sale turnover enhances the company’s ability to pay interest on debentures. If sales are rising, the company can use more of debt capital as it would be in a position to ay interest. But if sales are unstable or declining, it would not be advisable to employ additional debt capital.

4.    Control over Company. The control of a company is entrusted ot the Board of Directors elected by the equity shareholders. If the board of directors and shareholders of a company with to retain control over the company in their hands, they may not allow to issue further equity shares to the public. in such a case, more funds can be raised by issuing preference shres and debentures.

5.    Flexibility of Financial Structure. A goods financial structure should be flexible enough to have scope for expansion or contraction of capitalization whenever the need arises. In order to bring flexibility, those securities should be issued which can be paid off after a number of years. Equity shares cannot be paid off during the life time of a company. But redeemable preference shares and debentures can be paid off whenever the company feels necessary. They provide elasticity in the financial plan.

6.    Cost of Capital. Cost of raising finance by taping various sources of finance should be estimated carefully to decided which of the alternatives is the cheapest. Prevailing rate of interest, rate of return expected by the prospective investors, and administrative expenses are the various factors which affect the cost of financing. Generally, cost f financing by issuing debentures and preference shares for a reputed company is low. It is also essential to consider the floatation costs involved in the issue of shares and debentures, such as prating of prospectus, advertisement, etc.

7.    Period of Financing. When funds are required for permanent investment in a company, equity share capital is preferred. But when funds are required to finance expansion programmed and the management of the company feels that it will be able redeem the funds within the life-time of the company, it may issue redeemable preference shares and debentures.

8.    Market Conditions. The conditions prevailing in the capital market influence the determination of the securities to be issued. For instance, during depression, people do not like to take risk and so are not interested in equity shares. But during boom, investors are ready to take risk and invest in equity shares. Therefore, debentures and preference shares which carry a fixed rate of return may be marketed more easily during the periods of low activity.

9.    Types of Investors. The capital structure s influenced by the likings of the potential investors. Therefore, securities of different kinds and varying denominations are issued to meet the requirements of the prospective investors. Equity shares are issued to attract the people who can take the risk of investment in the company. Debentures and preference shres are issued to attract those people who prefer safety of investment and certainty of return on investment.

10.    Legal Framework. The structure of capital of a company is also influenced by the statutory requirements. For instance, banking companies have been prohibited by the Baking Regulation Act to issue any type of securities except equity shares.
   
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