Question

1. (a) Under what conditions do you think that the finance manager does not have to think about capital structure issue? (1 Mark)

(b) Discuss the various factors affecting the capital structure decisions giving appropriate examples. (1 Mark)

Answer 1

A.

•   Capital structure is the particular combination of debt and equity used by a company to finance it’s overall operation and growth.
•   A firm has to choose an appropriate mix of equity of debt in such a way that it maximize the value of firm. Any change in the debt- equity mix will have an impact on the value.
•   It has been observed that adding debt to capital structure of a firm increase the value of the firm up to a point. This point corresponds to the optimal capital structure. Beyond this point any increase in the debt the value starts decreasing again.
•   According to Modigliani and Miller if there are no corporate taxes the mix of debt and equity doesn’t matter and does not have any impact on the value of the firm. The value of firm is simply equal to operating income divided by the overall cost of capital.

B.

Various Factors affecting the Capital structure Decision:-

Control:- The management control over the firm is one of the major determinants of capital structure. Equity shareholders are considered as real owner of the company. Since they can participate in decision making through elected body of representatives as Board of Directors.
Risk:- In Capital structure Decision, two elements of risk viz.., Business Risk and Financial Risk. A firm with high Business Risk prefer to have low level of debt, so volatility of earning low. The higher proportion of debt increases the financial risk of the company with regard to fixed charge and repayment of principal amount in time.
Income:- Increase on return on equity shareholders depends on the method of financing and it’s impact on EPS and ROE.
Cost of capital:- Cost of different components of capital will influence the capital structure. A firm should posses earning power to generate revenues to meet its cost of capital and finance its future growth.
Time:- The time at which the capital structure Decision is taken will influenced by boom or recession conditions of the economy.
Legal provisions:- Legal provisions in raising capital will also play significant role in planning capital structure. Raising of equity capital is more complicated than raising debt.
Financing Purpose:- The capital structure Decision are taken in view of the purpose of financing. The long term projects are financed through long term sources and in the form of equity.
Government Policy:- Government Policy and capital regulations is major determinant in capital structure. For example increase in lending rates may cause the companies to raise Finance from capital market.