5 Marks Each

Question

Discuss the factores affecting the capital structure.

Vidyadip · Accepted Answer

External factors that affect the capital structure of the company:
$1.$ Condition of boom-depression in capital market:

When the market is low i.e. depressed, the investors prefer to invest safely in debentures rather than in risky equity. This earns them reasonable returns. On the other hand, when market is in boom, the investors invest in equity shares so as to earn higher dividends and profits.
Thus, how the capital structure will be formed is also decided by the trends prevailing outside the company in the capital market.

$2.$ Current rate of interest in capital market:

If the current rate of interest is high in capital market, companies prefer to raise capital by issuing equity shares rather than borrowing capital since borrowing at high interest proves costly for the company.
If the interest rate is less, companies also prefer debentures.

$3.$ Cost of capital expenses of issuing securities:

When a company issues securities for raising the capital, it has to incur several expenses. The expenses include releasing prospectus, underwriting commission, brokerage, etc. As a result, the cost of capital increases.
The expense on issuing debenture is lesser then issuing securities.

$4.$ Legal restrictions:

There are various legal restrictions which a company has to follow and hence they affect its capital structure.
As per Companies Act, the company raising capital fund through securities has to compulsorily issue equity shares. In addition to this, rules of $SEBI$ and $RBI$ and provision of Companies Act are also to be considered while formulating the capital structure.

$5.$ Taxation policy:

When the taxation is high, the companies prefer to issue debentures for acquiring capital. By doing so, the income tax gives deduction of interest paid on the debentures to the company.
Naturally, equity shares become more popular if the income of dividend is tax free or the rate is lower on the dividend income.

$6.$ Institutional investors:

Insurance companies, banks, financial institutions of state and central government, etc. invest in shares and debentures of the companies as per their established rules and conditions.
Trends and conditions of all these institutions are considered at the time of formulating capital structure or at the time of alteration of capital structure.

$7.$ Foreign institutional investor:

A financial institution established and registered outside India and whose objective is to invest in prescribed securities in India in primary and secondary markets is known as foreign institutional investor $(Fll).$
Foreign institutional investors have to get registered with $SEBI.$ Then, such institutions are permitted to purchase shares and debentures of Indian company.
Involvement of these institutions in the capital market of India affects the capital structure of the companies.

Answer