Before deciding the mix of long term sources of funds, it is necessary to consider a lot of factors which can be broadly

classified as: (a) Internal factors (b) External factors (c) General factors (a) Internal factors: Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of the capital should be capable of earning the revenue enough to meet the cost of capital. It should be noted here that the borrowed funds are cheaper than the equity funds so far as the cost of capital is concerned. This is because of two reasons: (a) The interest rates (i.e. the form of return on the borrowed capital) are usually less than the dividend rates (i.e. the form of return on the equity capital). (b) The interest paid on borrowed capital is an allowable expenditure for income tax purposes while the dividends are the appropriate out of the profits. Risk Factor: While planning the capital structure, the risk factor consideration inevitably comes into picture. If the company raises the capital by way of borrowed capital, it accepts the risk in two ways. Firstly, the company has to maintain the commitment of payment of the interest as well as the installments of the borrowed capital, at a predecided rate and at a predecided time, irrespective of the fact whether there are profits or losses. Secondly, the borrowed capital is usually the secured capital. If the company fails to meet its contractual obligations, the lenders of the borrowed capital may enforce the sale of assets offered to them as security. On the other hand, if the company raises the capital by way of equity capital, the risk on the part of the company is minimum. Firstly, as dividend is the appropriation of the profits, if there are no profits, the company may not be paying the dividend for years together, Secondly, the company is not expected to repay the equity capital, unlike borrowed capital, during the lifetime of the company. Thirdly, the company is not required to offer any security or mortgage its assets for raising the funds in the form of equity capital. Control Factor: While planning the capital structure and more particularly while raising additional funds, the control factor plays an important role, especially in case of closely held private limited companies. If the company decides to raise the long term funds by issuing further equity shares or preference shares, it dilutes the controlling interest of the present shareholders / owners, as the equity shareholders enjoy absolute voting rights and preference share holders enjoy limited voting rights. The control factor usually does not come into the picture in case of borrowed capital unless the lender of the long term funds, i.e. Banks or financial institutions, stipulate the appointment of nominee directors on the Board of Directors of the company. Objects of Capital Structure Planning: While planning the capital structure, the following objects of the capital structure planning come into play. (a) To maximize the profits of the owners of the company. This can be ensured by issuing the securities carrying less cost of capital. (b) To issue the securities which are easily transferable. This can be ensured by listing the securities on the stock exchange. (c) To issue the further securities in such a way that the value of shareholding of the present owners is not affected. (b) External Factors General Economic Conditions: While planning the capital structure, the general economic conditions should be considered. If the economy is in the state of depression, preference will be given to equity form of capital as it will be involving less amount of risk. But it may not be possible always as the investors may not be willing to take the risk. Under such circumstances, the company may be required to go in for borrowed capital. If the capital market is in boom and the interest rates are likely to decline in further, equity form of capital may be considered immediately, leaving the borrowed form of capital to be tapped in future. It may also be possible to raise more equity capital in boom as the investors may be ready to take risk and to invest.

Level of Interest Rates: If funds are available in the capital market, only at the higher rates of the interest, the raising of capital in the form of borrowed capital may be delayed till the interest rates become favorable. Policy of Lending Institutions: If the policy of term lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital, but the equity capital form should be tapped. Taxation Policy: Taxation policy of the Government has to be viewed from the angles of both corporate taxation and as well as individual taxation. The return on borrowed capital i.e. interest is an allowable deduction for income tax purposes while computing taxable income of the company, while return on equity capital i.e. dividend is not considered like that as it is the appropriation out of the taxable profits. As far as individual taxation is concerned, both interest as well as dividend will be taxable in the hands of lender of the capital subject to specified deductions available for the purposes. Statutory Restrictions: The statutory restrictions prescribed by the Government and various statutes are required to be taken into consideration before the capital structure is planned. The company has to decide the capital structure within the overall framework prescribed by the Government and various statutes. (c) General Factors: Constitution of Company: While deciding about the capital structure, the constitution of the company plays an important role. In case of private limited company, the control factor may be more important while in case of public limited company, cost factor may be more important. Characteristics of Company: Characteristics of the company, in terms of size, age and credit standing play very important role in deciding capital structure. Very small companies and the companies in their early stages of life have to depend more on the equity capital, as they have limited bargaining capacity, they cant tap various sources of raising the funds and they do not enjoy the confidence of the investors. Similarly, the companies having good credit standing in the market, may be in the position to get the funds from the sources of their choice. But this choice may not be available to the companies having poor credit standing. Stability of Earnings: lf the sales and earnings of the company are not likely to be stable enough over a period of time and are likely to be subject to wide fluctuation, the risk factor plays more important role and the company may not be able to have more borrowed capital in its capital structure as it carries more risk. However, if the earnings and sales of the company are fairly constant and stable over the period of time, it may afford to take the risk, where the cost factor or control factor may play important role. Attitude of the Management: lf the attitude of the management is too conservative, the control factor may play an important role in capital structure decision. If the policy of the management is liberal, the cost factor may get more importance.