What are the Factors that Determine the Capital Structure?

 The factor that influences capital structure decisions are as follows:

• Risk of cash insolvency

The risk related to cash insolvency arises due to the failure in paying the fixed interests in liabilities. Usually, the higher proportion of the debt in the capital structure compels the firm to pay a higher rate of interest on the debt, irrespective of the fact whether the fund is available or not. The non-payment of the charges in interest and the principal amount in time invites the liquidation of the company.

The abrupt withdrawal of debt funds from the organization can cause cash insolvency. In the determination of capital structure, the risk factor of a company has an important bearing, and it can be avoided if the project was financed by the issues of equity share capital.

• Risk in the variation of earnings

The higher the obligation contained in the capital structure of an organization, the higher will be the danger of variety in the normal income accessible to value investors. On the off chance that arrival on venture on absolute capital utilized (i.e., investors' reserve in addition to long term debt) surpasses the loan cost, the investors get a better yield.

Then again, if loan cost surpasses the degree of profitability, the investors may not get any arrival whatsoever.

• Cost of capital

The cost of capital refers to the cost of raising capital from various different sources of funds. It is the price paid for utilizing the capital. A business must generate sufficient revenue to fulfil its cost of capital and then finance the growth in the future. The finance manager must consider the cost of all sources of funds while designing the capital structure of a business.

• Control

The thought of holding control of the business is a significant factor in capital structure choices. On the off chance that the current value investors don't care to weaken the control, they may incline toward obligation money to value capital, as previously has no democratic rights.

• Trading on equity

The utilization of fixed enthusiasm bearing protections alongside proprietor's value as wellsprings of the fund is known as exchanging on value. It is a course of action by which the organization targets expanding the arrival on value shares by the utilization of fixed enthusiasm bearing protections (i.e., debenture, inclination shares, and so on).

On the off chance that the current capital structure of the organization comprises predominantly of the value shares, the arrival on value offers can be expanded by utilizing acquired capital. This is so on the grounds that the intrigue paid on debentures is a deductible use for personal expense evaluation, and the after-charge cost of debenture turns out to be extremely low.

Any abundance of income over the expense of obligation will be signified the value investors. In the event that the pace of profit for complete capital utilized surpasses the pace of enthusiasm on obligation capital or pace of profit on inclination share capital, the organization is supposed to exchange on value.

• Government policies:

Capital structure is usually influenced by Government policies, rules, and regulations of SEBI and the lending policies of financial institutions that change the financial pattern of the company completely. The government's monetary policy and the fiscal policy also affect the decisions related to capital structure.

• Size of the company

The size of the company influences the availability of funds. It is difficult for a small company to raise debt capital. The terms of long-term loans and debentures are less favorable for businesses. Small companies depend more on equity shares and retained earnings.

On the contrary, large companies issue different types of securities despite the fact that they have to pay less interest because the investors consider large companies less risky.

• Needs of the investors

While choosing a capital structure, the money related conditions and brain science of various sorts of financial specialists should be remembered. For instance, a poor or working-class speculator may just have the option to put resources into value or inclination shares, which are for the most part of little groups, just a monetarily stable financial specialist can bear to put resources into debentures of higher divisions.

A mindful financial specialist who needs his money to develop will lean toward equity shares.

• Flexibility

The capital structures of an organization ought to be with the end goal that it can raise assets as and when required. Adaptability gives space to development, both as far as lower sway on cost and with no noteworthy ascent in chance profile.

• Period of finance

The period for which account is required likewise impacts the capital structure. At the point when assets are required for term debt long (say ten years), it ought to be raised by giving debentures or preference shares. Assets ought to be raised by the issue of equity shares when it is required permanently.

• Nature of business

It has an extraordinary impact on the capital structure of the business, organizations having steady and certain profit lean toward debentures or preference offers, and organizations having no guaranteed pay rely upon inward assets.

• Legal requirements

The finance manager must comply with the legal provisions while designing the capital structure of a company.

• Purpose of financing

The capital structure of an organization is likewise influenced by the motivation behind the financing. On the off chance that the assets are required for assembling purposes, the organization may secure it from the issue of long haul sources. At the point when the assets are required for non-fabricating purposes, i.e., government assistance offices to labourers, similar to a class, clinic, and so on, the organization may acquire it from inward sources.

• Corporate taxation

At the point when corporate pay is liable to charges, obligation financing is good. This is made in light of the fact that the profit payable on value share capital and inclination share capital are not deductible for charge purposes, while intrigue paid on the obligation is deductible from pay and lessens an association's duty liabilities. The expense of saving money on premium charges decreases the expense of obligation reserves.

Besides, an organization needs to pay a charge on the sum conveyed as profit to the value investors. Because of this, complete income accessible for both obligation holders and investors is more when obligation capital is utilized in the capital structure. Along these lines, if the corporate assessment rate is sufficiently high, it is judicious to raise capital by giving debentures or taking long term debt advances from money related organizations.

• Cash inflows

The capacity of the business also affects the selection of capital structure in business for the purpose of generating cash flows. It also analyses the solvency position and the capability of the companies to meet its charges.

• Provision for future

The provision related to the future requirement of capital must also be considered amidst the planning of the capital structure of a business enterprise.

What is the optimal capital structure of a company?

 

What is the optimal capital structure of a company?

The optimal capital structure of a company is a combination of debt and equity financing that maximizes the market value of the company by minimizing the cost of the capital. 

However, a hefty amount of debt increases the financial risk to the shareholders, and the return on equity that they need.

What is a change in the working capital of a company?

The difference specified between the working capital for the two reporting periods is specified as the change in working capital. The changes in the working capital are included in cash flow operations because companies usually increase and decrease the current assets and current liabilities for funding their ongoing operations.

Corporate Finance - Effects of Debt on the Capital Structure

Using Greater Amounts of DebtRecall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.

With an increased debt load the following occurs: 
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all. 

In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.

Example:The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.

Answer:At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29

Recall that the minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.

Company vs. Stock ValuationThe value of a company's stock is but one part of the company's total value. The value of a company comprises the total value of the company's capital structure, including debtholders, preferred-equity holders and common-equity holders. Since both debtholders and preferred-equity holders have first rights to a company's value, common-equity holders have last rights to a company value, also known as a "residual value".

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/debt-effects-capital-structure.asp#ixzz1yezxSCbw

Video on WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
Read more: http://www.investopedia.com/video/play/what-is-wacc#ixzz1yfHGTd8N
http://www.investopedia.com/video/play/what-is-wacc#axzz1ybqROWiK

Quality check to weed out company with an insatiable demand for capital.

Quality check to weed out company with an insatiable demand for capital.

Benjamin Graham and followers placed great emphasis on financial strength, liquidity, debt coverage and so on. It was the tune of the times.

Credit analysis today continue to check all manner of coverage (e.g. interest coverage) and debt ratios, but for most companies reporting a profit, it maybe overkill.

Here are a few checks to provide a margin of safety and a further test of whether the company has an insatiable demand for capital:

1. Are current assets (besides cash) rising faster than the business is growing?

This ties to the asset productivity and turnover measures but it is worth one last check to see whether a company is buying business by extending too much credit.

More receivables result from extending credit.

Losing channel structure and supply chain battles (customers and distributors won't carry inventory; suppliers are making them carry more inventory) result in increased inventories.

In a soft construction environment, distributors and retailers like Home Depot and Lowe's simply aren't taking as much inventory, pushing it back up the supply chain. The main supplier's risk is greater capital requirements and expensive impairments downstream.

2. Is debt growing faster than the business growth?

Over a sustained period, debt rising faster than business growth is a problem.

If the owners won't kick in to grow the business, and if retained earnings aren't sufficient to meet growth, what does that tell you? The business is forced to seek capital.

3. Repeated trips to the financial markets?

If the business continually has to approach the capital markets (other than in startup phases), that again is a sign that internally generated earnings and cash flows are not sufficient.

Once in a while it is okay, but again one is looking to weed out chronic capital consumers.

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.