External factors affecting capital structure

a.    General economic conditions

While planning the capital structure, the company needs to consider the general conditions existing in the economy. If the economy is in boom and the interest rates are likely to decline, the company will like to raise equity capital immediately, leaving the borrowed capital to be considered in future. It may also be possible to raise more equity capital in boom as the investors may be ready to take risk and to invest. If the economy is in depression, the company will like to go for equity capital as it involves less amount of risk. However, it may not be possible to raise the capital by way of equity during the period of depression as the investors may not be required to go for borrowed capital.

b.    Behaviour of interest rates

While planning the capital structure, the company may be required to take into consideration the likely behaviour of interest rates in the economy. If the interest rates in the economy are likely to decline, depending more upon the long term sources carrying fixed rate of return (viz. debentures, preference shares) will prove to be dangerous for the company. If the interest rates in the economy are likely to increase, the company will get benefited by issuing the long term securities carrying fixed rate of return.

c.    Policy of the lending institutions

If the policy of the lending banks or financial institutions is too harsh or rigid, it will be advisable not to go for borrowed funds. Instead, the company will like to go for more convenient sources like leasing or hire purchase, though they are not more costly propositions.

d.    Taxation policy

Taxation policy as a factor affecting the capital structure decisions needs to be reviewed from the angle of the company as well as the investor.

As far as interest is concerned, from company’s point of view, the return paid on the borrowed capital i.e. interest is a tax-deductible expenditure. From investor’s point of view, return recieved by him on the funds lent to the company is a taxable income. Further, if the interest on debentures/bonds exceeds $ 2500 the paying company is required to deduct the tax at source and pay the same to the central government.

As such income received by the investors in their hands gets reduced to the extent of tax deducted at source.

As far as dividend, is concerned as per the provisions of section 10(36) of the income tax act, 1961, dividend received by the shareholders, whether interim or final, is not taxable in their hands. However, as per the provisions of section 115-O of the income tax act, the company paying the dividend is required to pay additional tax (over and above the normal income tax payable on the taxable profits of the company). This tax is in the form of tax distribution profits and the same is popularly referred to as dividend tax. Rate at which dividend tax is payable by the company is 12.5% of the amount of dividend paid. This basic rate is further increased by the surcharge of 10% and the education cess of 2%. As such, the effective rate of dividend tax works out as 14.025%. dividend tax is payable by the company within 14 days from the date of declaration or payment of dividend whichever is earlier.

e.    Statutory restrictions

The statutory restrictions prescribed by the government and various other statutes are required to be taken into consideration before the capital structure is planned by the company. The company has to decide the capital structure within overall framework prescribed by the government or various statutes.