'S' Ltd. is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is at about 7-8% and the demand for steel is growing. It is planning to set-up a new steel plant to capitalise on the increased demand. It is estimated that it will require about Rs 5000 crores to set-up and about Rs 500 crores of working capital to start the new plant.
What are the factors that will affect the capital structure of this company?
'S' Ltd. is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is at about 7-8% and the demand for steel is growing. It is planning to set-up a new steel plant to capitalise on the increased demand. It is estimated that it will require about Rs 5000 crores to set-up and about Rs 500 crores of working capital to start the new plant.
What are the factors that will affect the capital structure of this company?
Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is said to be optimum when the proportion of debt and equity is such that it increases the value of shares.
The factors that will affect the capital structure of this company are:
(i) Equity funds: The composition of equity funds in the capital structure will be governed by the following factors:
(a) The requirement of funds of 'S' Ltd is for long-term. Hence, equity funds will be more appropriate. But due to the long gestation period, returns will materialise much later, and a mix of more debt and less equity will be preferable. As per the imaginary plan, 4: 1 ratio of debt and equity is there. Thus equity must not be lesser than this; otherwise overall risk will increase.
(b) There are no financial risks attached to this form of funding.
(c) If the stock market is bullish, the company can easily raise funds through issue of equity shares.
(d) If the company already has raised a reasonable amount of debt funds, each subsequent borrowing will come at a higher Interest rate and will increase the fixed charges.
(ii) Debt funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:
(a) The availability of cash flow with the company to meet its fixed financial charges
The purpose is to reduce the financial risk associated with such payments, which can further be checked by using 'debt service coverage ratio'.
(b) It will provide the benefit of trading on equity and hence, will increase the Earning Per Share of equity shareholders. However, the 'Return on Investment' ratio will be the guiding principle behind it. The company should opt for trading on equity only when Return on Investment is more than the interest rate on debt.
(c) Interest on debt funds is a deductible expense and therefore, will reduce the tax liability and thus increase the gains of equity shareholders.
(d) It does not result in dilution of management control.
Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is said to be optimum when the proportion of debt and equity is such that it increases the value of shares.
The factors that will affect the capital structure of this company are:
(i) Equity funds: The composition of equity funds in the capital structure will be governed by the following factors:
(a) The requirement of funds of 'S' Ltd is for long-term. Hence, equity funds will be more appropriate. But due to the long gestation period, returns will materialise much later, and a mix of more debt and less equity will be preferable. As per the imaginary plan, 4: 1 ratio of debt and equity is there. Thus equity must not be lesser than this; otherwise overall risk will increase.
(b) There are no financial risks attached to this form of funding.
(c) If the stock market is bullish, the company can easily raise funds through issue of equity shares.
(d) If the company already has raised a reasonable amount of debt funds, each subsequent borrowing will come at a higher Interest rate and will increase the fixed charges.
(ii) Debt funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:
(a) The availability of cash flow with the company to meet its fixed financial charges
The purpose is to reduce the financial risk associated with such payments, which can further be checked by using 'debt service coverage ratio'.
(b) It will provide the benefit of trading on equity and hence, will increase the Earning Per Share of equity shareholders. However, the 'Return on Investment' ratio will be the guiding principle behind it. The company should opt for trading on equity only when Return on Investment is more than the interest rate on debt.
(c) Interest on debt funds is a deductible expense and therefore, will reduce the tax liability and thus increase the gains of equity shareholders.
(d) It does not result in dilution of management control.
