What is a Capital Structure?
Capital structure is a term given to the funds needed to run the company. It is one of the most important issues faced by the company. Mostly the capital structure is in the form of equity or debt. The choice of capital structure depends upon various factors. All companies should consider these factors while choosing the capital structure.
What are some of the Factors Which Influence the Choice of Capital Structure of a Company?
The factors on which the choice of capital structure depends are:
- Stability of Sales: It is considered by the companies while determining the capital structure. Companies with stable sales tend to raise more debt as compared to companies with unstable sales. Companies dealing in utility items tend to raise more debts as compared to industries.
- Structure of Assets: Companies which have high leverage such as real estate companies have general purpose assets which are suitable for collaterals. These are favored for debts. On the other hand companies using special purpose assets are not favored such as research companies.
- Profitability of the company: The companies with higher profitability or higher return on investments rely less on debts. These rely mostly on internally generated funds. It has positive effect on leverage of a company.
- Control of management: When the management has more than 50% voting power, it is easy to determine whether to have debt or equity as the capital structure.
- Taxes applicable: Companies which pay higher taxes tend to raise more debts as it will reduce the burden of taxes from their head.
- Growth rate of the company: The companies with higher growth rates rely more on external financing or debt rather than equity. They may rely on equity sometimes as there is uncertainty in growth rates.
- Operating Structure: Companies with less operational leverage are at lesser business risk. Therefore they have an easy choice to make their capital structure.
- Attitude of management: The attitude of the management may either be conservationist or aggressive. Conservationist attitude favors lesser debts and more internal funding while aggressive attitude favors more debts and lesser equity.
- Internal conditions of the company: If the company has high earnings they will prefer debts as they are reflected in the stock prices.
- Financial flexibility: The weak position of the company in the market forces it to have debts as capital structure.
- Conditions of market: Seeing the short and long term changes in the market, companies either use short term debts or long term debts to balance the leverage of the company.
- Stock Prices: Higher stock prices tend to issue equity rather than debt by a company. On the other hand companies in which there is reduction in stock prices tend to raise capital through debts.
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