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Financial management

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Financial management

  1. 1. FACTORS AFFECTING CAPITAL STRUCTURE DECISIONS SUBMITTED BY: AISWARYA.B 1st YEAR MBA BRIM
  2. 2. CAPITAL STRUCTURE DECISION  The capital structure is how a firm finances its overall operations and growth by using different sources of funds.  Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings.  Short-term debt such as working capital requirements is also considered to be part of the capital structure.
  3. 3. FACTORS DETERMINING CAPITAL STRUCTURE
  4. 4. Some of the Internal factors are:-  Profitability: While deciding or planning capital structure, the firm should keep the objective of maximizing the shareholders wealth. The firm shall work out proper EBIT- EPS analysis. Then only it can select that combination which gives highest value of EPS for a given level of EBIT.  Size of business: It is very difficult for small companies to raise long term debt. Hence they depend on share capital and retained earning. A large company requires large amount of capital. It cannot be raised from single source. Hence it has to rely on different types of securities or sources at reasonable cost. A medium size company is in a position to procure capital from all sources.  Period and Purpose of Financing: Equity shares are the best choice for funds required for permanent investment (long term). Debentures and preference shares are preferable for medium term finance. Preference shares and debentures are better for modernization and expansion.  Asset Structure: The quantity of fixed asset and current asset in the total assets also affect the capital structure. If a company has more fixed asset than current asset, it will use more debentures and preference share and less equity share. On the contrary if a company has more current assets, it may use more equity share capital.
  5. 5. Some of the Internal factors are:-  Capital Market Conditions: Capital structure is also influenced by the conditions of capital market. It determine the type of securities to be issued and also determine the rate of interest of debentures, rate of dividend on preference share etc. During depression, it is better raise capital through preference share and debentures and during boom period equity shares are better .  Cost of Financing: The cost of finance also exercise an important influence upon the selection of securities. It is desirable to employ cheapest source of finance to maximize returns. The cost of financing by debentures is cheaper than financing by issue of equity shares.  Statutory Requirement: While determining capital structure the company should take care of the relevant provision of various laws framed by the government from time to time. It should also take care of norms set by financial institution, SEBI, stock exchange etc.  Taxation Policy: High tax rate directly influences the capital structure decision. High tax discourages the issue of equity shares and encourages the issue of debentures. This is because the interest on debenture can be directly charged to P/L account for tax calculation.
  6. 6. FACTORS MAINLY INFLUENCING CAPITAL STRUCTURE DECISIONS 1. BUSINESS RISK 2. COMPANY’S TAX EXPLOSURE 3. FINANCIAL FLEXIBILITY 4. MANAGEMNT STYLE 5. GROWTH RATE 6. MARKET CONDITION
  7. 7. 1. BUSINESS RISK  Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.  Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?  The business risk does not include financing effects.
  8. 8. BUSINESS RISK IS AFFECTED PRIMARILY BY: Uncertainty about demand (sales). Uncertainty about output prices.  Uncertainty about costs. Product, others types of liability. Operating leverage
  9. 9. 2.COMPANY’S TAX EXPLOSURE  Debt payments are tax deductible.  Debt is not free either. Interest and fees paid to lenders form cost of debt – the less is the cost the more debt can be used.  One advantage of debt is that interest paid is deductible for the purposes of calculating income tax. Therefore, the more debt is used the less is the company’s effective tax rate.  As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
  10. 10. 3.FINANCIAL FLEXIBILIY  This is essentially the firm's ability to raise capital in bad times.  Companies raising capital when sales are growing and earnings are strong. Thus company's strong cash flow in the good times, raising capital is not as hard.  Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far.  The lower a company's debt level, the more financial flexibility a company has.
  11. 11. 4.MANAGEMENT STYLE  Management styles range from aggressive to conservative.  The more conservative a management's approach is, the less inclined it is to use debt to increase profits.  An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).
  12. 12. 5.GROWTH RATE  Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster.  The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.  More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven.  These firms also generate cash flow, which can be used to finance projects when they arise.
  13. 13. 6.MARKET CONDITION  Market conditions can have a significant impact on a company's capital- structure condition.  Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay.  In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
  14. 14. CONCLUSION  Thus every company needs capital to support its operations.  Capital structure is a blend of company’s sources of finance and consists of several types of funding.  To be more specific, capital structure is a ratio of short-term, long-term liabilities and equity.  Depending on the sources of financing, we can distinguish borrowed (or debt) capital and equity (owner’s capital).  Combined they form company’s employed capital.  Borrowed capital has some significant advantages.  Interest paid is exempt when calculating profit for tax.  Lenders receive only fixed income on provided funds and shareholder doesn’t have to share profit with them.
  15. 15.  Can improve return on capital  Harder to attract because lenders seek their own optimal risk-return ratio  Lower company’s solvency  Equity shares has some significant advantages i.e.  Simplicity in raising (no approval needed, only owner’s decision)  High rate of return on invested capital as interest on borrowed funds is not paid  Low risk of losing solvency and therefore lower risk of bankruptcy  Equity is limited so it’s impossible to increase business size significantly  Leverage is not used and total return is less than possible  Thus the companies should consider the above factors while determining the capital structure decision.

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