Question

Write the external factors influencing capital structure. 

Answer 1

1. Market Condition: -The pattern of capital is also influenced by prevailing market conditions. Readiness of investors to purchase shares, interest rate, stages of business cycle, tax, risk of investment, etc together form market conditions.

 

2. Attitude of Investor: -Attitude of investor also plays an important role in determination of capital structure. The investor s who is ready to take risk and expect higher returns prefer equity shares for investment. On the contrary, cautions investors, who are interested in safe and assured income, invest in debentures.

 

3. Cost of Capital: -Cost of capital is one of the important factors while designing capital structure. The cost of capital is the minimum return expected by its supplier. The expected return depends upon the degree of risk. The high degree of risk is assumed by shareholders than debt holder. In case of debt holder, the rate of interest is fixed, while rate of dividend given to shareholder is not fixed.

 

4. Government rules and regulation: -Statutory obligations play important role in capital structure decision. The SEBI has prescribed Debt: equity ratio norm of 2:1. A higher debt-equity ratio of 3:1 has been permitted for large capital intensive project. The small industrial projects are given concession and aid by government to avail more debt capital as compared to equity capital.

 

5. Attitude of financial institution: -If financial institution prescribes high terms of lending, then management has to move to other source of financing. If financial institutions prescribe easy terms of lending, it would be advantageous to obtain funds at cheaper rate.

 

6. Rate of Interest: -The prevailing rate of interest plays vital role in determining capital structure. If prevailing interest rates are higher, firms will delay debt financing. On the other hand, if prevailing interest rates are lower, firm will opt debt financing.

 

7. Taxation: -Interest paid against debt is tax deductable expenditure. Dividend is not considered as tax deductable expenditure for the company. As such, issue of debt is more advantageous than issue of share capital.

 

 

8. Competition:- The firm which are facing cut-throat competition prefer to issue equity shares because their earnings are not certain and adequate. But the companies which have monopolies may issue debt capital because of certainty of earnings.