The following are some important components of a company’s capital structure and they will therefore need proper analysis, consideration, evaluation and scrutiny.
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.
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.
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
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
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
These are some of the immediate
important questions a company may have to consider while deciding on the target
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
Last 30 days 581 views