Factors Determining Capital Gearing
Factors Determining Capital Gearing
There are many factors which determine capital gearing of a company. The important factors are as follows:
Trading on equity :
Trading on equity means an opportunity to raise dividend on equity shares by issuing fixed interest bearing securities.
For example, A company issuing Equity Shares of 10,00,000 and earning a profit of Rs. 1,00,000 can pay a dividend of 10% (1,00,000 x 100/ 10,00,000)
Supposing the company raises this capital by issuing Rs. 5,00,000 worth of Equity Shares and Rs. 5,00,000 worth of 6% Preference Shares. If the company earns the same profit of Rs. 1,00,000. This dividend on Equity Shares will rise from 10% to 14% after paying 6% dividend on Preference
Shares i.e. Rs. 30,000 (5,00,000 x 6/100)
Total Profit 1,00,000
Less 6% Dividend on Pref. Sh. (6/100 × 5,00,000) 30,000
Profit available to Equity Shareholders 70,000
This will give a dividend of 14% on Equity Shares (70,000 x 100 / 5,00,000)
It should be noted that trading on is possible only if the rate of profit earned by the company is more than the rate of interest payable on fixed interest bearing securities.
Retaining control on company’s management:
Existing share holders may like to retain control on the company’s management. This they can do by issuing securities with no voting right or by issuing debentures. In case the management issuing Equity Shares, it is possible that the management of the company may pass on in the hands of rival group.
Stability of earning :
An enterprise having stable income should have highly geared capital structure, i.e. It can issue fixed interest bearing securities. It will be difficult for a company having fluctuating earnings to pay interest on bonds or debentures. A company having monopoly in the market will have regular and high earnings as it will not have to face competition from other firms. As such it can raise capital by issuing bonds and debentures.
Flexibility of capital structure:
Capital structure of a company should be flexible so that it can survive in case there are inadequate or no profit. In case the company issues more fixed interest-bearing securities like Preference Shares, bonds or debentures, the capital structure will become rigid. It will not be able to service the loans, i.e. pay interest to the bond or debenture holders in case its earnings are not good.
Legal requirements :
Ordinarily a company is free to issues any type of securities. However, a banking company in India can issue only equity shares, it cannot issues preference shares.
Types of investors:
A company issue different types of securities to attract different types of investors. Risk taking investors prefer to take equity shares because they expect unlimited return on such shares. They are guided by the principle of greater the risk greater is the profit. On the other hand, cautious type of investors or investors who want a certain fixed return on their investment prefer to take preference shares or debentures. They are also assured of return of capital in preference to equity share holders in case the company is unable to pay its debts and goes into liquidation.
Money market conditions :
Money market conditions also play an important role in shaping the capital structure of a company. During boom period investors prefer to invest their funds in equity shares to take the advantage of higher profits and consequently higher dividends. On the other hand, during economic depression, investors prefer to invest in fixed interest bearing securities as they want a certain guaranteed return on their investment.
Period for which finance is required :
Finance may be required to meet long term capital requirements or short term capital requirements. It is usual to raise capital for long term requirements by the issue of equity shares or preference shares. However, capital required for short term needs is raised by arranging short term loans from banks. Capital required for expansion programmes is raised through issue of redeemable preference shares or debentures.
Types of assets to be financed:
Types of assets to be financed also plays an important role in deciding the capital structure. Funds required to finance fixed capital i.e. to buy fixed assets such as land and buildings or plant and machinery are raised through issue of equity shares. On the other hand, funds needed to finance working capital i.e. current assets such as stock of raw material are raised by arranging loans from banks or financial institutions.
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