DETERMINANTS OF CAPITAL STRUCTURE
The capital structure of a concern depends upon a large number of factors such as leverage or trading
on equity, growth of the company, nature and size of business, the idea of retaining control,
flexibility of capital structure, requirements of investors, cost of floatation of new securities, timing
of issue, corporate tax rate and the legal requirements. It is not possible to rank them because all such
factors are of different importance and the influence of individual factors of a firm changes over a
period of time.
The factors influencing the capital structure are discussed as follows:
1. Financial Leverage or Trading on Equity: The use of long term fixed interest bearing debt and
preference share capital along with equity share capital is called financial leverage or trading on
equity. The use of long term debt increases, magnifies the earnings per share if the firm yields a
return higher than the cost of debt. The earnings per share also increase with the use of preference
share capital but to the fact that interest is allowed to be deducted while computing tax, the leverage
impact of debt is much more.
2. Growth and Stability of Sales: The capital structure of a firm is highly influenced by the growth
and stability of its sales. If the sales of a firm are expected to remain fairly stable, it can raise a higher
level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed
commitments of interest payment and repayments of debt. Similarly, the rate of growth in sales also
affects the capital structure decision.
3. Cost of Capital: Every dollar invested in a firm has a cost. Cost of capital refers to the minimum
return expected by its suppliers. The capital structure should provide for the minimum cost of capital.
The main sources of finance for a firm are equity, preference share capital and debt capital. The
return expected by the supplier of capital depends upon the risk they have to undertake. Usually, debt
is a cheaper source of finance compared to preference and equity capital due to (i) fixed rate of
interest on debt. (ii) legal obligation to pay interest.
4. Risk: There are two types of risk that are to be considered while planning the capital structure of a
firm viz. (i) business risk and (ii) financial risk. Business risk refers to the variability to earnings
before interest and taxes. Business risk can be internal as well as external. Internal risk is caused due
to improper products mix, non availability of raw materials, incompetence to face competition,
absence of strategic management etc. internal risk is associated with efficiency with which a firm
conduct its operations within the broader environment thrust upon it. External business risk arises
due to change in operating conditions caused by conditions thrust upon the firm which are beyond its
control e.g. business cycle. Financial risk refers to the possibility of a corporation or government
defaulting on its bonds, which would cause those bondholders to lose money.
5. Cash Flow: A firm which shall be able to generate larger and stable cash inflows can employ more
debt in its capital structure as compared to the one which has unstable and lesser ability to generate
cash inflow. Debt financial implies burden of fixed charge due to the fixed payment of interest and
the principal. Whenever a firm wants to raise additional funds, it should estimate, project its future
cash inflows to ensure the coverage of fixed charges.
6. Nature and Size of a Firm: Nature and size of a firm also influence its capital structure. All public
utility concern has different capital structure as compared to other manufacturing concern. Public
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utility concerns may employ more of debt because of stability and regularity of their earnings. On the
other hand, a concern which cannot provide stable earnings due to the nature of its business will have
to rely mainly on equity capital.
Control: Whenever additional funds are required by a firm, the management of the firm wants to
raise the funds without any loss of control over the firm. In case the funds are raised through the
issue of equity shares, the control of the existing shareholder is diluted. Hence they might raise the
additional funds by way of fixed interest bearing debt and preference share capital. Preference
shareholders and debenture holders do not have the voting right. Hence, from the point of view of
control, debt financing is recommended. But, depending largely upon debt financing may create
other problems, such as, too much restrictions imposed upon by the lenders or suppliers of finance
and a complete loss of control by way of liquidation of the company.
Flexibility: Capital structure of a firm should be flexible, i.e. it should be such, as to be capable of
using adjusted according to the needs of the changing conditions. It should be possible to raise
additional funds, whenever the need be, without much difficulty and delay. A firm should arrange its
capital structure in such a manner that it can substitute one form of financing by another.
Requirement of Investors: The requirement of investors is another factor that influences the capital
structure of a firm. It is necessary to meet the requirements of both institutional as well as private
investors when debt financing is used. Investors are generally classified under three kinds, i.e. bold
investors, cautious investors and less cautious investor.
Capital Market Conditions (Timing): Capital Market Conditions do no remain the same for ever
sometimes there may be depression while at other times there may be boom. When the market is
depressed and there are pessimistic business conditions, the company should not issue equity shares
as investors would prefer safety.
Inflation: Another factor to consider in the financing decision is inflation. By using debt financing
during periods of high inflation, we will repay the debt with dollars that are worth less. As
expectations of inflation increase, the rate of borrowing will increase since creditors must be
compensated for a loss in value. Since inflation is a major driving force behind interest rates, the
financing decision should be cognizant of inflationary trends.
Legal Considerations: At the time of evaluation of different proposed capital structure, the financial
manager should also take into account the legal and regulatory framework. For example, in case of
the redemption period of debenture is more than 18 months, then credit rating is required as per SEBI
guidelines. Moreover, approval from SEBI is required for raising funds from capital market whereas;
no such approval is required- if the firm avails loans from financial institutions. All these and other
regulatory provisions must be taken into account at the time of deciding and selecting a capital
structure for the firm.
DETERMINANTS OF DIVIDEND POLICY IN FINANCIAL MANAGEMENT
Dividend
Dividend refers to the corporate net profits distributed among shareholders. Dividends can be
both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a
percentage every year to the preference shareholders if net earnings are positive. After the payment
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of preference dividends, the remaining net profits are paid or retained or both depending upon the
decision taken by the management.
Determinants of Dividend Policy
1. Stability of Earnings. The nature of business has an important bearing on the dividend policy.
Industrial units having stability of earnings may formulate a more consistent dividend policy
than those having an uneven flow of incomes because they can predict easily their savings and
earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than
those dealing in luxuries or fancy goods.
2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A
newly established company may require much of its earnings for expansion and plant
improvement and may adopt a rigid dividend policy while, on the other hand, an older company
can formulate a clear cut and more consistent policy regarding dividend.
3. Liquidity of Funds. Availability of cash and sound financial position is also an important
factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the
liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very
much on the investment and financial decisions of the firm which in turn determines the rate of
expansion and the manner of financing. If cash position is weak, stock dividend will be
distributed and if cash position is good, company can distribute the cash dividend.
4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A
closely held company is likely to get the assent of the shareholders for the suspension of
dividend or for following a conservative dividend policy. On the other hand, a company having a
good number of shareholders widely distributed and forming low or medium income group
would face a great difficulty in securing such assent because they will emphasise to distribute
higher dividend.
5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their
financial position. The income may be conserved for meeting the increased requirements of
working capital or of future expansion. Small companies usually find difficulties in raising
finance for their needs of increased working capital for expansion programmes. They having no
other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at
low rates and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy
is adjusted according to the business oscillations. During the boom, prudent management creates
food reserves for contingencies which follow the inflationary period. Higher rates of dividend
can be used as a tool for marketing the securities in an otherwise depressed market. The financial
solvency can be proved and maintained by the companies in dull years if the adequate reserves
have been built up.
7. Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control and other government policies. Sometimes
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government restricts the distribution of dividend beyond a certain percentage in a particular
industry or in all spheres of business activity as was done in emergency. The dividend policy has
to be modified or formulated accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the
rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of
dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond
10 % of paid-up capital are subject to dividend tax at 7.5 %.
9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements
too into consideration. In order to protect the interests of creditors an outsiders, the companies
Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend.
Moreover, a company is required to provide for depreciation on its fixed and tangible assets
before declaring dividend on shares. It proposes that Dividend should not be distributed out of
capita, in any case. Likewise, contractual obligation should also be fulfilled, for example,
payment of dividend on preference shares in priority over ordinary dividend.
10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in
mind the dividend paid in past years. The current rate should be around the average past rat. If it
has been abnormally increased the shares will be subjected to speculation. In a new concern, the
company should consider the dividend policy of the rival organisation.
11. Ability to Borrow. Well established and large firms have better access to the capital market
than the new Companies and may borrow funds from the external sources if there arises any
need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to
depend on their internal sources and therefore they will have to build up good reserves by
reducing the dividend payout ratio for meeting any obligation requiring heavy funds.
12. Policy of Control. Policy of control is another determining factor is so far as dividends are
concerned. If the directors want to have control on company, they would not like to add new
shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders
they fear dilution of control and diversion of policies and programmes of the existing
management. So they prefer to meet the needs through retained earing. If the directors do not
bother about the control of affairs they will follow a liberal dividend policy. Thus control is an
influencing factor in framing the dividend policy.
13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one other arrangements are made for the redemption of debt on
maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly
institutional lenders) put restrictions on the dividend distribution still such time their loan is
outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency
to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend
payout.
14. Time for Payment of Dividend. When should the dividend be paid is another consideration.
Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a
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time when is least needed by the company because there are peak times as well as lean periods of
expenditure. Wise management should plan the payment of dividend in such a manner that there
is no cash outflow at a time when the undertaking is already in need of urgent finances.
15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because
each investor is interested in the regular payment of dividend. The management should, in spite
of regular payment of dividend, consider that the rate of dividend should be all the most constant.
For this purpose sometimes companies maintain dividend equalization Fund.
DETERMINANTS OF WORKING CAPITAL IN FINANCIAL MANAGEMENT
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There are no set rules or formulae to determine the working capital requirements of a firm.
The level of working capital is influenced by a number of factors. In this section let us examine the
influencing factors.
Nature of Business is one of the factors. Usually in trading businesses the working capital needs are
higher as most of their investment is found concentrated in stock. On the other hand,
manufacturing/processing business need a relatively lower (compared to that of trading business)
level of working capital. The terms of ‘higher’ and ‘lower’ used above are relative and not absolute.
That is, of the total capital employed in the businesses a higher or lower, as the case may be, portion
is employed in current assets.
Sales and Demand Conditions of a firm also affect its working capital position. It is difficult to
precisely determine the relationship between volume of sales and working capital needs. Sales
depend on the demand conditions. Most of the firms experience seasonal and cyclical fluctuations in
the demand of their products and services. These business variations affect the working capital
requirement, particularly the temporary working capital requirement of the firm. When there is an
upward swing in the economy, the sales will increase and untimely the firm’s investment in
inventories and debtors will also increase. On the other hand, when there is a decline in the economy,
the sales will fall and ultimately, the level of inventories and debtors will also fall. Under
recessionary conditions firms try to reduce their short-term borrowings.
Manufacturing Policy: The manufacturing cycle of the firm also affects the requirement of the
working capital. The manufacturing cycle comprises the purchase and use of raw material and
production of finished goods. Longer the manufacturing cycle, larger will be the firm’s working
capital requirements and vice versa. An extended manufacturing time span means a larger tie-up of
funds in inventories. Further, the requirement of working capital also depends on whether the firm
has adopted steady production policy or variable production policy.
Credit Policy: In the present day circumstances, almost all units have to sell goods on credit. The
nature of credit policy is an important consideration in deciding the amount of working capital
requirement. The larger the volume of credit sales, the greater will be the requirement of working
capital. Generally, the credit policy of an individual firm depends on the norms of the industry to
which the firm belongs. Credit periods also influence the size and composition of working capital.
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When longer credit period is allowed to customers as against the one extended to the firm by its
suppliers, more working capital is needed and vice versa. In the former case, there will be a relatively
higher trade debtors and in the latter there will be a higher trade creditors.
Collection policy is another influencing factor. A stringent collection policy might not only deter
away some credit seeking customers, also force existing customers to be prompt in settling dues
resulting in lower level of working capital. The opposite is true with a liberal collection
policy. Collection procedures do influence the level of working capital. A decentralized collection
of dues from customers and centralized payments to suppliers, shall reduce the size of working
capital. Centralized collections and centralized payments or decentralized collections and
decentralized payments would lead to a moderate level of working capital. But with centralized
collections and decentralized payments, the working capital need will be the highest.
The Availability of Credit from banks and financial institutions also influences the working capital
requirement of a firm. The availability of credit to a firm depends upon the creditworthiness of the
firm in the money market. If a firm has good credit standing in the market, it can get credit easily on
favorable terms and hence it will require less working capital.
The Operating Efficiency of the firm relates to the optimum utilization of resources at minimum
costs. If the firm is efficient in controlling its operating costs and utilizing its current assets, than it
helps in keeping the working capital at a lower level. The use of working capital is improved and
pace of cash conversion cycle is accelerated with operating efficiency.
The Price Level Changes also affect the level of working capital. Generally, rising price levels will
require a firm to maintain higher amount of working capital. However, the effect of rising prices may
be different for different companies, though the general price level increases, the individual prices
may move differently. Therefore, some firms may require more working capital, while other may
require less working capital in case of price rise.
Inflation has a bearing on level of working capital. Under inflationary conditions generally working
capital increases, since with rising prices demand reduces resulting in stock pile-up and consequent
increase in working capital.
Level of trading is another factor. There are two levels of trading, viz. over trading and under
trading. Over trading means the business wants to maximize turnover with inadequate stock level,
hastened production cycle and swiftest collection from debtors. Eventually the working capital will
be lower. It is no good, however, for the business is starved of its legitimate working capital needs.
Under trading is the opposite of over-trading. There is lethargy and over lags. The results are a higher
working capital. This is no good either, since the working capital is not effectively utilized. It is
wastage of capital.
The Growth and Expansion Plans to be undertaken by a firm also affect its requirements of
working capital. Hence the planning of the working capital requirements and its procurements must
go hand in hand with the planning of the growth and expansion of the firm. Even the expansion of
the sales also increases the requirements of working capital.
System of production process is another factor that has a bearing. If capital intensive, high
technology automated system is adopted for production, more investment in fixed assets and less
investment in current assets are involved. Also, the conversion time is likely to be lower, resulting in
further drop in the level of working capital. On the other hand, if labor intensive technology is
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adopted less investment in fixed assets and more investment in current assets (especially work-inprogress due to inclusion of an enhanced wage component and prolonged processing) result.
Finally rapidity of turnover comes. There is a negative correlation between rapidity of turnover and
size of working capital. When sales are fast and swift, lower is the investment in working capital.
Actually stock of inventory is very minimum. But, when sales are happening far and in-between, i.e.
rather slow, as in the case of jewellery, elaborate investment in working capital results. Thus faster
sales lead to lower working capital and vice versa.
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