Page 203 - DCOM508_CORPORATE_TAX_PLANNING

Corporate Tax Planning

Notes (ii) Low geared companies: Those companies whose equity capital dominates total
capitalisation.

Example: There are two companies A and B. Total capitalisation amounts to be ` 200,000
in each case. The ratio of equity capital to total capitalisation in company A is ` 50,000, while
in company B, ratio of equity capital is ` 150,000 to total capitalisation, i.e., in Company A,
proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered
to be a highly geared company and company B is low geared company.
9.1.1 Factors Determining Capital Structure

Various factors which are kept in mind by a firm while deciding on its capital structure are:
1. Trading on Equity: The word “equity” denotes the ownership of the company. Trading on
equity means taking advantage of equity share capital to borrowed funds on reasonable
basis. It refers to additional profits that equity shareholders earn because of issuance of

debentures and preference shares. It is based on the thought that if the rate of dividend
on preference capital and the rate of interest on borrowed capital is lower than the general
rate of company’s earnings, equity shareholders are at advantage which means a company
should go for a judicious blend of preference shares, equity shares as well as debentures.
Trading on equity becomes more important when expectations of shareholders are high.
2. Degree of control: In a company, it is the directors who are so called elected representatives
of equity shareholders. These members have got maximum voting rights in a concern as
compared to the preference shareholders and debenture holders. Preference shareholders
have reasonably less voting rights while debenture holders have no voting rights. If the
company’s management policies are such that they want to retain their voting rights in
their hands, the capital structure consists of debenture holders and loans rather than equity
shares.
3. Flexibility of fi nancial plan: In an enterprise, the capital structure should be such that there
are both contractions as well as relaxation in plans. Debentures and loans can be refunded
back as the time requires. While equity capital cannot be refunded at any point which
provides rigidity to plans. Therefore, in order to make the capital structure possible, the
company should go for issue of debentures and other loans.
4. Choice of investors: The company’s policy generally is to have different categories of
investors for securities. Therefore, a capital structure should give enough choice to all kind
of investors to invest. Bold and adventurous investors generally go for equity shares and
loans and debentures are generally raised keeping into mind conscious investors.
5. Capital market condition: In the lifetime of the company, the market price of the shares has
got an important influence. During the depression period, the company’s capital structure

generally consists of debentures and loans. While in period of boons and infl ation, the
company’s capital should consist of share capital generally equity shares.
6. Period of fi nancing: When company wants to raise finance for short period, it goes for loans

from banks and other institutions; while for long period it goes for issue of shares and
debentures.
7. Cost of fi nancing: In a capital structure, the company has to look to the factor of cost when

securities are raised. It is seen that debentures at the time of profit earning of company prove

to be a cheaper source of finance as compared to equity shares where equity shareholders
demand an extra share in profi ts.
8. Stability of sales: An established business which has a growing market and high sales
turnover, the company is in position to meet fixed commitments. Interest on debentures

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