The investment decision of a firm is generally known as the capital budgeting or capital decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years.

The firm’s investment decisions would generally include expansion, acquisition, modernization, and replacement of long-term assets. ‘Sales’ of a division or business (divestment) is also as an investment decision.

Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans, and retained earnings. The term capital structure refers to the relationship between the various long-term source financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure is the important decision of financial management because it is closely related to the value of the firm.

*The exchange of current funds for future benefits.

*The funds are invested in long-term assets.

*The future benefits will occur to the firm over a series of years.

MAJOR CONSIDERATION IN CAPITAL STRUCTURE DECISION

There are there major consideration, i.e. risk, cost of capital and control which help the financing manager in determining the proportion in which he can raise funds from various sources.

Risk: Risk is of two kinds, i.e., Financial risk and business risk. Here we are concerned primarily with the financial risk also following

Risk of Cash insolvency: As a firm raises more debt, its risk of cash insolvency increases. This is due to two reasons. Firstly, a higher proportion of debt in the capital structure increases the commitments of the company with regard to fixed charges. This means that a company stands committed to pay a higher amount of interest irrespective of the fact whether it has cash or not.

Cost of Capital

Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization.

When the cost of capital increases, the value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital.

Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of a long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.

Size of the company: It also affects the capital structure of a firm. If the firm belongs to a large scale, it can manage the financial requirements with the help of internal sources. But if it is a small size, they will go for external finance. It consists

of a high cost of capital.

Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources.

A requirement of investors: In order to collect funds from a different type of investors, it will be appropriate for the companies to issue different sources of securities.

Control: Along with cost and risk factors, the control aspect is also an important consideration in planning the capital structure. When a company issues future equity shares, it automatically dilutes the controlling interest of the present owners, similarly, preference shareholders can have voting rights and thereby affected the composition of the board of directors in case dividends on such shares are not paid for two consecutive years.

Government policy

Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds from external sources. Hence the company must consider government policy

regarding the capital structure.

Corporate Taxation: Under the income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. Cost of raising finance through borrowing is deductible in the year in which it is incurred.

Legal Requirements: The finance manager has to keep in view the legal requirements while deciding about the capital structure of the company.

Marketability: To obtain a balanced capital structure it is necessary to consider the ability of the company to market corporate securities.

Flexibility: Flexibility refers to the capacity of the business and its management to a list of expected and unexpected changes in circumstances. In other words, management would like a capital structure which provides maximum freedom to changes at all times.