## Fundamental Principles Governing Capital Structure

While designing the capital structure of a company, the following principles must be considered:

### 1. Cost Principle

An ideal capital structure is one that minimises the cost of capital and maximises earnings per share (EPS).
Lower cost of capital → higher residual earnings for equity shareholders.

### 2. Risk Principle

Reliance should be placed more on common equity for financing capital requirements than excessive use of debt.
More debt → higher commitment in the form of interest payout.
In unfavourable business conditions, fixed interest obligations can erode shareholders' value.

### 3. Control Principle

The finance manager should design the capital structure such that existing management control and ownership remain undisturbed.
Issuing too many new equity shares dilutes control of existing shareholders.
Loans from financial institutions may bring director nominations → loss of control.

### 4. Flexibility Principle

The chosen combination of sources should be one that the management finds easier to adjust according to future changes in fund requirements.
Avoid restrictive covenants that limit future borrowing capacity.

### 5. Other Considerations

Besides the above principles, also consider:

Nature of industry (capital intensive vs. service)
Timing of issue (market conditions)
Competition in the industry

### Mnemonic

"CR-CO-F + Others" → Cost, Risk, COntrol, Flexibility, plus Other considerations.

Worked example

### Example 1

Q (May 16 — 4 Marks / Nov 12 — 4 Marks): State the principles that should be followed while designing the capital structure of a company.

A: Five fundamental principles: (i) Cost Principle — minimise cost of capital and maximise EPS; (ii) Risk Principle — favour equity over excessive debt to control financial risk; (iii) Control Principle — preserve existing management control; (iv) Flexibility Principle — choose easily adjustable sources; (v) Other Considerations — industry, timing, competition.

⚠️ Common exam mistakes

Listing only 3 principles (cost/risk/control) and missing flexibility and other considerations.
Confusing 'Risk Principle' with 'cost of capital' — risk principle is about avoiding over-leverage; cost principle is about minimising WACC.
Not mentioning the consequence under each principle (e.g., why excessive debt is risky — fixed interest payouts in bad times).

Reference:

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