Wednesday, April 12, 2017

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Factors Determining Capital Structure

FACTORS DETERMINING CAPITAL STRUCTURE:

The following factors are considered while deciding the capital structure of the firm.

(1). Leverage:

It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital.

(2). Cost of Capital:

Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization.

When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital considering the following:

finance
[Post Image Courtesy of JK1991 at FreeDigitalPhotos.net]

(a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.

(b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital.

(c) Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources.

(d) Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.

(3). Government policy: Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds from external sources. Hence the company must consider government policy regarding the capital structure.

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