Capital structure decisions are one of the most vital decisions of a firm other than the Capital budgeting decisions and Working Capital decisions. Capital structure decisions deal with the choice between the different types of sources of finance. A firm can raise capital from various sources, such as common stocks, preferred equity, Short-term Debt, Long-term Debt, etc. Each source of funding is different in nature and carries a different charge. While lenders of Debt are paid with fixed, regular interest, equity, and preference, shareholders are paid a dividend out of the remaining income. They can be postponed in case of no profit. Unlike equity, usage of Debt source of finance created a fixed charge on the company, i.e., a firm has to pay interest on Debt irrespective of the level of profits.
Capital structure means a composition of equity and Debt source of finance in the total capital of the firm. According to Pandey (2005), “The term Capital structure represents the proportionate ratio of Debt and equity.” “Capital structure of the firm is the composition of several alternatives of Debt and equity that have to be utilized for the creation of a pool of funds and to finance a company’s assets” (Bhaduri, 2002). As Debt and equity sources differ on the basis of their risk class and return, deciding an appropriate level of Debt in the financial structure is vital for a firm. An inappropriate Capital structure may have its impact not only on the risk and return of the shareholders but also on the survival of the firm.
Pandey, Ranjit, and Chotigent, (2000), states that “the combination of Debt and equity in the Capital structure implies a Trade-off between return and risk.” Therefore, great attention should be paid while selecting the funds and forming the Debt-equity ratio, as excessive Debt in the Capital structure results in high risk and the problem of survival of the firm. A large share of Debt in the Capital structure leads to massive interest payments to the lenders, decreasing the return to the equity holders as well as the value of the firm. On the other hand, Excessive equity usage will deprive the firm of higher income and higher value of the firm, as Debt is considered as the cheaper sources of finance. Hence, in order to have a balanced Capital structure, it is necessary to have the correct ratio of Debt and equity.
The capital structure, which reduces the total cost of the capital and thus maximizes the value of the firm, is referred to as ‘optimum capital structure.’ Hence, the optimum Capital structure is related with two important factors, the maximization of the firm’s value as well as minimization of the total Capital cost. Keeping in view the objective of the firm, i.e. to maximize the shareholder’s wealth, the role of capital structure decisions is crucial and to examine the determinants of optimum capital structure is not an easy task. There is no standard proportion of Debt to equity ratio to be used by every firm as the firms differ in their nature of business activities.
The decisions regarding the Capital structure are governed by various factors like the Size of the firm, Profitability of the firm, Growth rate, Ratio of fixed assets to total assets, the Volatility of income, Liquidity, etc. Hence, the capital structure of a firm is designed taking into account the unique characteristics of the firm. However, Sector or the Industry to which a firm belongs may have some similar characteristics, and thus, the firms related to a particular industry may have similar capital structures. For instance, firms in the Energy or the Construction sector need huge capital investments upfront, whereas firms in the Information Technology industry needs lesser capital compared to other industries. Mining firms may not be entirely sure about the consistency of the income and therefore, may not be able to service the Debt, whereas the Consumer Goods firms, due to their lesser volatile income, can avail a large amount of Debt funds.
Factors affecting Capital Structure
There are multiple macroeconomic as well as Firm-specific factors that affect the Capital structure choice of a firm. They are as under:
Macroeconomic factors:
- Inflation rate
- Trade openness
- Legal environment
- State of Equity market
- Corporate bond market
- Tax rate
- Accounting practices
Firm-Specific factors:
- Size of the business
- Growth opportunities
- Age of the firm
- Profitability
- Liquidity position
- Working Capital requirements
- Tangibility of Assets
- Nature of business risk
- Non-Debt tax shields
- Coverage ratio of the firm
- Dividend payout
- Product Uniqueness
- Type of Industry
For citing this article use:
- Ghayas, A. (2019). A Study of Relationship Between Capital Structure and Profitability of the Selected Companies in India.
