Factors affecting Optimal Capital Structure

Capital Structure
It is the combination of different sources of funds to finance the company. There are two broad sources of finance available with the firm Shareholders Fund Loan funds

Shareholders Fund
Equity capital Retained earnings Preference capital

Loan Funds
Debenture capital Term loans Deferred credit Fixed deposits Working capital advance

Difference
Capital structure is the amount of capital owned by the company whereas Optimal Capital structure is the amount of capital which company maintains while seeing its cost. Optimal Capital Structure is achieved when the cost of capital is lowest. At this point the market price per share is maximum.

Factors Affecting Capital Structure

Cost Nature of Assets Business Risk Norms of Lenders Control considerations Market conditions

1) Cost
Debt is a cheaper but riskier source of finance whereas equity is a costlier but safer source of finance.

2) Nature of Assets
If the assets are primarily tangible ( plant, machinery and buildings ) and have a liquid resale/secondary market, Debt finance is used more. If Intangible assets ( brands and technical know how ) are used, debt finance is used less. Example Software companies.
Reason : Lenders are more willing to lend against tangible assets rather than intangible ones.

3) Business Risk?
Uncertainty about future operating income (EBIT).It is influenced by the following factors :
Demand Variability : Higher the variability higher is the risk.

Price variability

: Higher degree of volatility higher is the degree of business risk )

Variability of Input Prices : High variability higher risk.

Proportion of Fixed operating costs :If fixed cost represents a substantial proportion of total cost others being equal, business risk is likely to be high. 9

4) Norms of Lenders
The norms employed by lenders also have a bearing on the capital structure. Generally debt/equity ratio is 2:1 but it could be 2.33/1 for capital intense projects.

5) Control considerations
The extent of equity stake that the promoters want to have in a project has an important bearing in the capital structure.

6) Market Conditions
If the equity market is buoyant and equity shares can be issued at an attractive premium, the project may rely more on equity. When market is depressed the project may depend more on debt.

Conclusion
Use more Equity when
The tax rate applicable is negligible Business risk exposure is high Dilution of control is not an important issue The asset of the project are mostly intangible The project has many valuable growth options

Use more debt when

The tax rate applicable is high Business risk exposure is low Dilution of control is an issue The assets of the project are mostly tangible The project has few growth.