Financing Decisions & Capital Structure

Once an enterprise determines that it requires Rs. 50 crores to construct a new manufacturing facility, a critical question arises: Where will this money come from? Should the promoters issue new equity shares, borrow through bank loans, issue corporate debentures, or use accumulated retained earnings? This fundamental choice is known as the Financing Decision.

1. What is a Financing Decision?

The Financing Decision is concerned with determining the optimal composition of long-term capital sources (equity shares, preference shares, debentures, retained earnings, and long-term bank loans) to fund corporate investments at the minimum overall cost of capital while keeping financial risk within safe limits.

Core Trade-Off: Risk vs Cost

• Debt Capital (Borrowing): Cheaper source of funds because interest is tax-deductible. However, debt introduces financial risk—the legal obligation to pay interest and repay principal regardless of whether the business makes a profit.
• Equity Capital (Ownership Shares): Safe source because there is no legal compulsion to pay dividends or return capital during normal operations. However, equity is expensive (investors demand higher returns for risk) and dilutes existing promoter voting control.

2. Concept of Capital Structure

The Capital Structure refers to the permanent long-term financing mix of a company, represented by the proportionate relationship between debt and equity securities on its balance sheet.

Key Formula

Capital Structure Ratio = Long-Term Debt / Net Worth (Equity Share Capital + Free Reserves)

An Optimal Capital Structure is the debt-equity mix that maximizes the market price of the company’s equity shares while minimizing its Weighted Average Cost of Capital (WACC).

3. The Power of Financial Leverage & Trading on Equity

Financial Leverage (or Trading on Equity) refers to the use of fixed-cost securities (debentures and preference shares) in the company’s capital structure in the hope of increasing the Earnings Per Share (EPS) of equity shareholders.

How Trading on Equity Works (A Concrete Example)

Consider two companies needing Rs. 10,00,000 total capital with operating profit (EBIT) of Rs. 2,00,000 (20% return on capital employed):

Key Insight

Because Company B utilized 10% debt, its equity shareholders earned Rs. 2.10 per share, which is 50 percent higher than Company A’s Rs. 1.40 per share!

• When it works: When Return on Capital Employed (ROCE) > Cost of Debt.
• The Danger (Double-Edged Sword): If operating profits drop below the 10 percent interest rate, financial leverage turns negative, severely crashing EPS and threatening bankruptcy.

4. Factors Influencing Financing Decisions

When structuring corporate capital, finance managers examine several internal and external determinants:

┌────────────────────────────────────────────────────────────────────────┐
│                  DETERMINANTS OF FINANCING DECISION                    │
├──────────────────────────┬─────────────────────────────────────────────┤
│ 1. Cash Flow Stability   │ Firms with stable, predictable daily cash   │
│                          │ flows (e.g., utility companies) can safely  │
│                          │ take on higher debt.                        │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 2. Interest Coverage     │ Interest Coverage Ratio (EBIT / Interest)   │
│    Ratio (ICR)           │ measures the safety buffer for paying debt. │
│                          │ Higher ICR allows more debt borrowing.      │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 3. Corporate Tax Rate    │ Since interest is tax-deductible, higher tax│
│                          │ rates make debt financing cheaper.          │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 4. Control Consideration │ If promoters fear losing voting control,    │
│                          │ they prefer debt over issuing fresh equity. │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 5. Floatation Costs      │ Legal, advertising, and underwriting fees   │
│                          │ are higher for public equity than bank debt.│
├──────────────────────────┼─────────────────────────────────────────────┤
│ 6. Capital Market Mood   │ In a roaring bull market, equity is easily  │
│                          │ absorbed at premium prices.                 │
└──────────────────────────┴─────────────────────────────────────────────┘

5. Major Sources of Long-Term Finance in India

1. Internal Sources:
   • Retained Earnings (Ploughing Back of Profits): The cheapest and safest capital source with zero floatation costs and zero dilution of voting control.
2. External Equity Sources:
   • Equity Shares: Permanent capital providing safety and borrowing capacity.
   • Preference Shares: Fixed dividend payout without voting rights.
3. External Debt Sources:
   • Non-Convertible Debentures (NCDs): Long-term corporate debt sold to institutional and public investors.
   • Term Loans from Commercial Banks: Customized project loans from public and private commercial banks (SBI, HDFC).
   • External Commercial Borrowings (ECBs): Foreign currency loans raised from international markets under RBI guidelines.

6. Summary for BBA Exams

• Financing Decision: Choosing the optimal proportion of debt and equity capital.
• Debt vs Equity: Debt is cheaper and tax-deductible but increases financial default risk; equity is safe but expensive and dilutes control.
• Trading on Equity: Using fixed-cost debt to boost Earnings Per Share (EPS) for equity owners when ROCE > interest rate.
• Key Determinants: Cash flow stability, Interest Coverage Ratio (ICR), corporate tax rate, management control, and capital market trends.