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Financial Management - CAPITAL STRUCTURE THEORIES

Composition of capital structure

   Posted On :  20.06.2018 03:24 am

The following are some important components of a company’s capital structure and they will therefore need proper analysis, consideration, evaluation and scrutiny.

Composition of capital structure
 
The following are some important components of a company’s capital structure and they will therefore need proper analysis, consideration, evaluation and scrutiny.
 

Capital mix

 
It consists of the equity and debt capital. The debt capital which can be raised from a variety of sources like banks and financial institutions, friends and relatives, etc forms an important item of the capital mix.
 
The percentage of debt capital to the total capital mix will depend on the extent of dependence of debt affordable by the company. And this dependence will in turn depend on the risks undertaken by the company. The lenders will consider these risks on their part before lending their resources to the company.
 
Issues like reasonableness of the debt terms, its mechanism and the policies, systems and procedures of the company will also be looked into. Ratios like debt ratio, debt service coverage ratio, etc will be handy and helpful in framing up the action plan on capital mix. Cash flow and funds flow statements will also help one in analyzing the capital mix for decision making.
 

Terms and conditions

 
A debt can be acquired with many choices on hand. The interest thereon can be either on fixed or floating rate basis. In the case of equity, the investors would prefer regular return by way of dividends.
 
The company will have to decide its preference either for payment of interest or payment of dividends. In case debt capital can be raised at a lower rate of interest than the return on such borrowed capital, then it would be advisable to prefer debt capital to ensure maximum return for the owners. Again, the company’s expectation of future interest rates will be yet another consideration. If, the future interest rates are remaining neutral and if the company’s earnings are at a growing pace, then it may be ideal to go in for debt capital.
 
Therefore, the company’s choice will depend on the management’s assessment of future interest rates and its earnings potential. Of course, the management will take into account hedging instruments available at its disposal for managing such interest rate exposures.
 
There is certain covenant in the loan documentation like what the company can do and cannot do. And these may inhibit the freedom of the management of the company. They normally cover payment of dividends, disposal of fixed assets, raising of fresh debt capital, etc. How these covenants prohibit and limit the company’s future strategies including competitive positioning.
 

Selection of currency of the debt

 
The currency of the debt capital is yet another factor to reckon with. Now a days, a well run company can easily have access to international debt markets through external commercial borrowings.
 
Such recourse to international markets enables the company to globalize its operations. However, the most important consideration in the selection of the appropriate currency in which such international loans are granted and accepted is the exchange risk factor. Of course, the management can have access to foreign exchange hedging instruments like forward contracts, options, swaps, etc.
 

Profile and priority

 
The profile of the instruments used in the capital mix may differ from each other. Equity is the permanent capital. Under debt, there are short term instruments like commercial papers and long term instruments like term loans.
 
In the same manner the priorities of the instruments also differ. Repayment of equity will have the least priority when the company is winding up – either on its own or by legal force.
 
Instruments such as hire purchase or leasing are quite safe from the provider’s (lender’s) point of view. The assets backing such instruments provide the protection or safety net to the lenders. Therefore secured debts are relatively safe and have priority over unsecured debt in the event of company closure.
 
Normally the profile of the assets and liabilities of the company do not match. The company is deemed to have obtained risk neutral position by matching the maturities (profile) of the various assets and liabilities. That is why it is always advised that short term liabilities should be used to acquire current assets and long term liabilities for fixed assets.
 
However in practice, the companies do not exactly match the profile of sources and uses of funds.
 

Various financial instruments

 
Simple instruments or innovative instruments can be availed to raise funds required. Financial innovative instruments are used to attract investors and they are normally associated with reduction in capital cost. A company to reduce its immediate funding cost can consider issue of convertible debentures at a lower interest rate. This way the investors can take up equity holding in the company which is not otherwise available directly at a comparatively cheaper cost. For the company too funds are available initially till the conversion date at a lesser interest rate.
 
A company can also issue non convertible debentures at a higher interest rate when compared with convertible debentures, which may carry a lower interest rate as above. Similarly a company can attempt raising required funds at a lesser cost through cross currency swaps in the international markets. In this, the company which may be having competitive advantage in one currency and in one market can exchange the principal with another currency of its choice and in another market and with another corporate which has an exactly matching and opposite requirement. Such swaps are gaining popularity in the market place
 
Therefore, the company and its management have to continuously innovate instruments and securities to reduce the final cost. An innovation once introduced may not attract new investors. There is also a possibility and the other companies may further fine tune the instruments and securities and make them more innovative and attractive. Therefore financial innovation is a continuous process.
 

Various target groups in financial market

 
The different target groups in any financial market could be individual investor, institutional investors, private companies and corporates, public (government held or widely held) companies and corporates etc.
 
A company can raise its required capital from any of these or all of these segments. A company can issue short term paper like commercial paper or certificate of deposits. It has also the option of raising the funds through public deposits.
 
How these various target groups can be accessed? What are their expectations and requirements? What are the target groups the company is proposing to approach for its requirements and why?
 
These are some of the immediate important questions a company may have to consider while deciding on the target group
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