Evolution of Capital Structure Alternatives: Explained

When a business company requires finance, then it issues various types of securities, like equity shares, preference shares, and debentures, etc. So How the alternatives of capital structure are evaluated?

evolution of capital structure alternatives
evolution of capital structure alternatives

Besides, whenever additional capital is required by the existing company, then the problems arising before the directors of the business company are:

  1. By issue of what type of security, the additional capital may be raised.
  2. By issue of equity or preferences share or debentures.
  3. By issuing all three.

The above problems of the capital issue may be solved by the comparative study of income, risks, and control.

Evolution of Capital Structure Alternatives

Availability of new finance have the following effects on the income, risk, and control of the shareholders:

  1. Effects of equity shares.
  2. Effects of preference shares.
  3. Effects of debentures.

Effects of Equity Shares

If the additional finance of any company is arranged by the issue of equity shares, it will have the following effect on the equity, income, risks, and control of existing shareholders:

1. Equity

If the new equity shares are issued on the basis of the right of pre-emption of the existing shareholders, then there will be no effect on their equity.

But, if shares are sold without their right of pre-emption, then their equity will reduce.

Related: 15 Essential Features of Venture Capital (in Simple Words).

2. Income

Equity shareholders are such a person who has the ultimate right to the income of the company.

The equity shareholders have the right on all residual amount after deducting all expenses from income, paying interest to the debenture holders, paying tax, and by paying returns to preference shareholders.

Besides, if the new equity shares are issued on the basis of the right of pre-emption, then they share income remains the same as it is.

But, if equity shares are issued without that, then they share in income, of existing equity shareholders reduces because of partnership in residual income increases.

Not only that, many a time their income is almost negligible, in case of reinvestment of the profits.

Thus, the success or failure of the company depends upon the income of the shareholders.

3. Risk

The real risk of the company is Borne by the equity shareholders.

But, the risks of the existing shareholders get reduced, on the issue of new shares, because the new shareholders also bear the risk of the company.

4. Control

As regards control, maximum control of the company is of equity shareholders.

If the new shares are issued with the right of pre-emption, the control of existing shareholders will remain unchanged.

But, if new shares are not issued on the basis of the right of pre-emption, then the control of existing shareholders reduce, as their proportion in total votes becomes low.

Related: 18 Major Factors Affecting Capital Structure (Complete List).

Effect of Preference Shares

If the new financial arrangements are made by the company through the issue of preference shares, its effects on equity, income, risk, and control of existing equity shareholders will be, as follows:

1. Equity

We know that preference shareholders are not the real owner of the company.

Hence, equity among equity shareholders continuous to maintain.

The preference shareholders, usually do not have voting rights and they are not partners in residual income also.

Thus, they are given dividends as the fixed rate.

2. Income

Dividend at a fixed rate is paid to the preference shareholders from the income of the company.

Evolution of Capital Structure Alternatives
Capital Structure Evolution

Hence, during days of depression, the effect on income at equity shareholders is adverse.

The effect is, however, favorable in periods of Boom.

3. Risks

The status of preference shareholders is in between the equity shareholder and debenture holder because he has the preference in getting dividend at the fixed rate on his investment.

Hence, they have to bear less risk on the liquidation of the business of the company, as compared to equity shareholders.

But, their position is not good as of debenture holders, because their profit is on the amount left after payment to debenture holders.

Hence, it may be said that the risk of preference shareholders is less than that of the equity shareholders but more than that of the debenture holders.

Related: Trading On Equity: Objectives, Types, Importance, Limitations.

4. Control

As regards the question of control, the preference shareholders have not right on operation and control of the business.

Hence, the control continues to remains in the hands of existing equity shareholders, even after the supply of new finances.

Effects of Debentures

If the managers of the company arrange additional capital by issue of debentures, then its effects on equity, income, risk, and control of existing equity shareholders are as follows:

1. Equity

We know that the debenture holders owe from the company and they are not the owners of the company.

Hence, they have no right to share the residual income.

Hence, the issue of debentures has no adverse effect on the equity of equity shareholders.

2. Income

The debenture holders get income at the pre-decided rate in the form of interest.

If the income earning capacity of the company is more than this interest rate, then the dividend to equity shareholder increases, due to the increase in the residual income.

3. Risk

Although the risk of debenture holders depend upon the conditions of the contract between the company and debenture holders.

However, the debenture holders have to bear the least risks, because they have a preference over the properties of the company.

Besides, they have the right to get returns, like, means interest, before equity and preference shareholders and they are also assured for the timely return of the original money.

The issue of debentures for procuring additional finances increases the risk of equity shareholders.

4. Control

As regards control, usually the debenture holders have no right in the management and control of the company.

Hence, the control of equity shareholders of the company continuous, as usual.

But, in case of note-making timely payment of interest and original money of the debentures, the control of the company may slip in the hands of the debenture holders.

Thus, Now you know How the alternatives of capital structure are evaluated.

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