Selecting source of capital, amount of capital utilized and its relative importance determines the financial structure of a company. In designing its policies relating to sources of capital, this general structure must be given adequate attention, for the use of one source of capital affects the worth and value of other sources.
The source of capital of a company is determined by various factors like the size of the undertaking by a company, nature of undertaking, the nature and type of its assets, the amount and stability of its earnings, the position of the financial market, etc., determine the source of capital to be utilized by the company for financing its business.
From time to time, the source of capital is changed, either because it can be profitably procured from some other source of finance or because some lender decides to withdraw his capital from the company. The expansion and contraction in the total capital that is employed, affect the relative importance of different sources of capital for the company. Therefore, the financial structure of the company should be based on a proper correlation and the adoption of financial policies in relation to existing conditions.
Selecting source of capital:
The financial structure of a company provides a base for managers to decide about the options to be deployed for procuring source of capital for the company. It has been noted that, among different companies, there is great variation in capital structure — in assets, in earnings, in the style of management; but in industries dealing is similar types of goods, the capital structure tends to be the same. An effective financial management would ensure that the capital structure of the company is tailor-made. Therefore, while deciding about the capital structure of the company, the management should bear the following factors in mind:
- The use to be made of the capital;
- The cost of capital;
- The rights granted to various contributors.
Use of Capital
The funds required to finance temporary or seasonal needs can be effectively obtained from short-term creditors, such as commercial banks which are good source of capital. This is a relatively easy and inexpensive method of raising capital and facilitates immediate reduction in the capital so owned after its requirements have been fully met. On the other hand, the finances required for fixed assets or working capital that will be permanently retained in business should be raised by issuing securities or from financial institutions.
The use of capital also affects the company’s ability to offer the lender some special security for his loan. As effective guarantee that the loan will be paid well in time, the company may pledge as security one or more assets (such as inventories, machinery, plant and buildings). In this way, it will be able to procure the loan of the desired amount.
Cost of Capital
In business undertakings, capital in the form of shares and debentures has to be attracted and retained. Therefore, the management in assessing the cost of capital, must give due consideration to the original cost in obtaining it as well as to the compensation paid for its use.
The total cost of maintaining loan and share capital should be kept to the minimum, alternative capital structures should be compared, for different proportions of loan capital and share capital yield different results. Different alternative sources of capital at different time periods should therefore be taken into consideration. If other things remain equal, the one which attracts the minimum cost should be chosen. However, care should be taken to ensure that the terms of cheapest loan do not impose any restrictions on the company which are likely to impair its ability to earn maximum profit. In assessing cost of capital, the following elements should be given adequate consideration.
Underwriting and Registration
Underwriting and registration are another alternate source of capital for a company. The companies procuring capital by the issue of bonds or selling stock to public incur considerable amount of expenditure. Securities and stocks are sold through brokers and underwriters, who are resourceful enough to reach prospective buyers. Companies therefore pay a substantial amount of compensation to them for their services. Capital or finance raised by way of sale of property involves legal formalities and publicity cost. Therefore, while procuring capital, the management must see to it that it is able to raise money at minimum cost.
Issue of Rights Shares raises source of capital:
The companies issuing new securities generally sell them directly to this existing shareholders. Issuing of rights shares plays an important role as a good source of capital for a company. This is particularly true when a company sells additional stock of a similar nature. Some companies have a clear policy to the effect that, on a fresh issue, the existing shareholders will be given priority. When that is the case, if the stock is sold at below market price, the present stockholders will take full advantage of the privilege. When this situation exists, the cost of securing additional capital is made very easy. But, even then it is always desirable to enlist the services of underwriters and brokers, failing which many items of expenditure relating to the sale of securities will have to be incurred.
Adjusting sources to Prevailing Rate of Interest:
The compensation that is paid for the use of capital varies not only with the way in which it is used but is materially affected by the state of the business cycle.
Many companies, in order to rise source of capital, find it desirable to sell bonds and other long-term securities when low interest rates prevail in order to safeguard themselves against the high cost that they anticipate in future when interest rates would be high. A company may raise funds through short-term loans on the presumption that these can be paid off from the proceeds of long-term bonds which will be sold in future when interest rates are lower. The success of such a plan depends on the efficiency with which the management forecasts the movement of interest rates. But there is always an apprehension that interest rates on long-term obligations will be higher when short debts mature. Moreover, the corporate taxation structure plays such an important role in the profitability of companies that the timing to changes in the capital structure may be based on an attempt to get the most desirable tax structure
Return Paid on New Stock
Whenever new stock is sold, the company is not obliged to pay a specific amount of interest for the use of capital so procured. Moreover, when new stockholders are paid any dividend, there is a reduction in the dividend of existing shareholders. This sharing of dividend is the cost of capital so far as the existing shareholders are concerned.
Many companies find it desirable to raise capital by issuing stock even though it is anticipated that the dividends paid would be definitely higher than the interest that would have been paid on bonds, if the latter had been issued. The willingness of companies to pay higher cost is linked with the fact that dividends do not have to be paid if there are no adequate earnings or cash to justify the declaration of a dividend. Contrary to this, the interest on bonds is required to be paid regardless of the amount of earnings or cash in hand.
It is largely assumed that source of capital can be procured at any time, provided that a fair compensation is made available to the public. But, as a matter of fact, the sale of bonds or stock during certain phases of the business cycle may be so difficult that source of capital cannot be procured from these.
Rights Granted with new securities for source of capital:
Rights Granted to Creditors for providing source of capital:
In selecting the source of capital, adequate attention should be given to the authority attached to the different types of capital. If capital is procured from short-term creditors, the latter will have no control over the affairs of the company. But if they are not compensated in time, they may resort to legal action for the enforcement of their claims.
Long-term creditors are also a means for the source of capital. The do not ordinarily have a voice in the current affairs of the company; but a bond-holder may impose certain restrictions on the management. For example, by indenture he may restrict the future debts that the company can incur, or he may insist that the amount be invested in fixed assets, etc. The loan agreement may also restrict the freedom to declare and pay a dividend. Some agreements provide that a dividend cannot be paid if the ratio between the various type of assets is below the prescribed limit, or if there is any default in the payment of interest to long-term creditors. If these requirements are not met and a dividend is declared, legal action can be taken by the bond-holders against the company. These restrictions at times become so cumbersome that the managements prefer to procure source of capital from other means.
Rights Granted to Stockholders for providing source of capital:
If source of capital is procured by the sale of stock, new stockholders will have certain rights against the company. Quite often, they have full voting rights and they become participants in the future management of the company. In most cases, present stockholders want to retain control of the management and do not want new stockholders to participate in the affairs of the company. The possibility that the sale of stock will change the balance of power among the members of the Board of Directors largely depends upon the size of the new issue as compared to the existing stock, the amount of stock held by existing shareholders and the extent to which existing stockholders purchase the new stock.
The preference shareholders do not exercise any control over the affairs of the company. Normally, they have no right of vote in the election of directors, as equity shareholders have. However, common stockholders usually run the risk of losing control to preference stockholders, if the preference stock remains unpaid for a long time and the charter provides that, under such circumstances, preference stockholders can be given the voting power.