Factors Affecting Capital Structure of a Company

Factors affecting cap. Structure of the company

Before deciding the mix of long term sources of funds, it is necessary to consider a lot of factors which can be broadly classified as:

(a) Internal factors

(b) External factors

(c) General factors

(a) Internal factors:

Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of the capital should be capable of earning the revenue enough to meet the cost of capital. It should be noted here that the borrowed funds are cheaper than the equity funds so far as the cost of capital is concerned. This is because of two reasons:

(a)        The interest rates (i.e. the form of return on the borrowed capital) are usually less than the dividend rates (i.e. the form of return on the equity capital).

(b)        The interest paid on borrowed capital is an allowable expenditure for income tax purposes while the dividends are the appropriate out of the profits.

Risk Factor: While planning the capital structure, the risk factor consideration inevitably comes into picture. If the company raises the capital by way of borrowed capital, it accepts the risk in two ways. Firstly, the company has to maintain the commitment of payment of the interest as well as the installments of the borrowed capital, at a predecided rate and at a predecided time, irrespective of the fact whether there are profits or losses. Secondly, the borrowed capital is usually the secured capital. If the company fails to meet its contractual obligations, the lenders of the borrowed capital may enforce the sale of assets offered to them as security.

On the other hand, if the company raises the capital by way of equity capital, the risk on the part of the company is minimum. Firstly, as dividend is the appropriation of the profits, if there are no profits, the company may not be paying the dividend for years together, Secondly, the company is not expected to repay the equity...