What are guiding principles of capital structure? (2024)

Finance manager has to decide the right combination of capital based on certain principles and available source of funds to maximize returns. Guiding principles of capital structure are as follows −

• Cost principle
• Risk principle
• Control principle
• Flexibility principle
• Timing principle
• Cost principle −
  • Main concern of this principle is to earn maximum Earnings per share with minimum cost of financing.
  • Interest rates and tax rates controls cost of financing.
  • Debt capital is cheaper.
• Risk principle
  • Main concern of this principle is that it will not accept stiff risks.
  • High rates on debts than earnings may lead liquidity trap.
  • Declaration of dividends is voluntary.
  • Encourages equity and limits debt as a source of funds.
• Control principle
  • Main concern of this principle is to issue preferred shares to keep control with owners.
  • Maintains balance between equity and debt.
• Flexibility principle
  • Main concern of this principle is to have extra funds for future needs.
  • Management has to use their sources effectively for long term funds (if needed).
• Timing principle
  • Main concern of this principle is to make use of their opportunities in dynamic markets.
  • Cost of raising funds is minimized.