Factors Affecting Capital Structure Decisions

Factors Affecting Capital Structure Decisions The following factors significantly influence the capital structure decision of a firm: Economy Characteristics The major developments taking place in the economy affect the capital structure of firms. In order words, the way the  economy of a country is managed determines the way the capital structure of a firm will be determined. Factors that are active in the economy are:

1. Business activity: The quality of business activity prevailing in the economy determines the capital structure pattern of a firm. Under conditions of expanding business activities, the firm must have several alternatives to source the required capital in order to undertake profitable investment activities. Under these circumstances, it is advisable for a firm to undertake equity funding rather than debt funding.

2. Stock market: The buoyancy, or otherwise, of the capital market greatly influences capital structure decisions. A study of the capital market trends would greatly help a firms decision on the quantum and cost of issue. Accordingly, if the stock market is expected to witness bullish trends, the interest rates will go up and debt will become costlier.

3. Taxation: The rates and rules of taxation prevalent in an economy also affect capital structure decisions. For instance, higher rates of taxation will be advantageous due to the tax deductibility benefit of debt funding. Similarly, the taxes on dividend income, if any, would adversely affect the ability of firms to raise equity capital.

4.  Regulations: The regulations imposed by the state on the quantum, pricing etc. of capital funds to be raised also influences the capital raised by a firm. For instance, restrictions have been imposed by SEBI on the issue and allotment of shares and bonds to different type of investors. A finance manager should take this factor into consideration while designing the capital structure.

5.  Credit Policy: The credit policy pronouncements made by the central monetary authority, such as the RBI, affects the way capital is raised in the market. For instance, the interest rate liberalization announced by RBI has been dominating the lending policies of financial institutions. This affects the ability of finance managers to raise the required funds.

6.  Financial Institutions: The credit policy followed by financial institutions determines the capital structure decisions of firms. For instance, restrictive lending terms by financial institutions may deter firms from raising long-term funds at reasonable rates of interest. Easy terms, on the other hand, may encourage firms to obtain a higher quantum of loans.