A company in course of charting out its financial schema has to take into account two things.
1) The amount of capital to be raised.
2) Make-up of the capital.
Decisions regarding the composition or capitalization are reflected in capital structure. Capital structure of a firm is a combination of debt and equity, which supports long term financing of the firm. The pattern of capital structure has to be planned very carefully by the finance manager in such a way that it minimizes the cost of capital and maximizes value of stocks, thus protecting the interest of the share holders.
Which of the above most suits a firm depends on multifarious internal and external factors within which a firm operates.
A firm can raise substantially large amount of fund by issuing different types of shares. The money thus raised is a permanent source of resource and without any obligation to refund to the respective owners. Small and growing companies go for equity fund raising as no banks or other financial institutions are prepared to fund these firms in lieu of poor credit worthiness. Even big corporate firms opt for issuing equities when there is a need to raise large sums. But smaller firms, whose major share of capital comprises of common stock, have to be careful, in that, some large concerns might become interested in controlling these stocks. The one big advantage of equity shareholders is that they are free to trade the shares in the market. They can sell the shares to anybody at any time and if the market warrants, at a higher price. One has really nothing to lose, if he is planning to invest in equities. On the other hand, if the company goes bankrupt, the share holders stand a chance to receive only the residual amount, after the creditors’ claims are cleared and satisfied.
Debt has a maturity date upon which the stipulated sum of principal is repaid. It places the burden of obligation on the shoulders of the company in the form of periodical interest settlements and principal repayments. Creditors can go for legal action if the company defaults in payment of the assured sum on the specific date. That’s why companies think twice before they go for issuing debentures and other bonds. One good thing for the company is that, it can avail tax rebate on the securities of debt, but at the other end it has to satisfy the interest payments and factorise the cost of capital.
Cost principle supports induction of additional doses of debt, but it might prove risky, if the company is not able to service the additional debt. Control principle supports the issue of bonds in order to tighten the rein of ownership, but maneuverability principle discounts this and favors issue of common stock to reduce the interest burden. Four factors are important in the purview of the finance manager, cost, risk, control and timing. He should be able to evolve a pattern that satisfactorily brings a compromise among these conflicting factors, which are then assigned weights in the wake of economic and industrial characteristics.