Before deciding the mix of various long term sources of funds, it is necessary for the company to take into consideration various factors which can be broadly classified as below:

a.    Internal factors

Cost factor

Cost factor as the factor affecting the capital structure decisions refers to the cost associated with the process of raising the various long term sources of funds which is referred to as cost of capital. While deciding the capital structure, it should be ensured that the use of capital is capable of earning enough revenue to justify the cost of capital associated with it. It should be noted that the borrowed capital is a cheaper form of capital for the company and this is due to the following reasons:

1.    The expectations of the lenders of borrowed funds (viz. debentures, term loans etc.) are less than the expectations of the investors who invest in own capital of the company (viz. shares). This is due to the fact that the risk on the part of lender of borrowed funds is comparatively less than the risk on the part of investors in own funds.

2.    The return which the company pays on borrowed funds (i.e. interest) is an income tax deductible expenditure for the company whereas the return paid on own capital (i.e. dividend) is not an income tax deductible expenditure for the company. As such, when the company pays the interest on borrowed capital, its tax liability gets reduced, whereas payment of dividend does not affect the tax liability of the company as the same is paid out of profit after taxes.

b.    Risk factor

In financial terms, risk and return always go hand in hand. Whichever capital is cheap for the company is risky for the future company. Cost associated with the borrowed funds may be less, but the borrowed capital is more risky for the company. This is due to the following reasons.

1.    Payment of interest at the predetermined rate of interest at the predetermined time intervals irrespective of non-availability of profits is a contractual obligation for the company.

2.    The company is required to repay the principal amount of borrowed capital at the predetermined maturity date.

3.    Borrowed capital is usually secured capital. If the company fails to meet its contractual obligations, the lenders of borrowed funds may enforce the sale of assets offered to them as security.


Cost associated with the own funds may be more for the company, but the risk associated with them is less. This is due to the following reasons.

1.    As the return paid on own capital i.e. dividend is the appropriation of profits, the company is not bound to repay any dividend unless there are profits. There are many companies who have not paid any dividend on equity shares for years together due to non-availability of profits.

2.    The company is not expected to repay the own capital during the lifetime of the company.

3.    Own capital is an unsecured capital. As such, none of the assets of the company are offered as the security to the investors in own funds.