Capital Structure Concept

Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders”-P. Chandra.

The relative proportion of various sources of funds used in a business is termed as financial structure. Capital structure is a part of the financial structure and refers to the proportion of the various long-term sources of financing. It is concerned with making the array of the sources of the funds in a proper man­ner, which is in relative magnitude and proportion.

The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

Again, each component of capital structure has a different cost to the firm. In case of companies, it is financed from various sources. In proprietary concerns, usually, the capital employed, is wholly contributed by its owners. In this context, capital refers to the total of funds supplied by both—owners and long-term creditors.

The question arises: What should be the appropri­ate proportion between owned and debt capital? It depends on the financial policy of individual firms. In one company debt capital may be nil while in another such capital may even be greater than the owned capital. The proportion between the two, usually expressed in terms of a ratio, denotes the capital structure of a company.

Definition of Capital Structure:

Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, prefer­ence share capital and shareholders’ funds.

According to Gerestenberg, “Capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and bonds”.

Keown et al. defined capital structure as, “Balancing the array of funds sources in a proper manner, i.e. in relative magnitude or in proportions”.

In the words of P. Chandra, “Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders”.

Hence capital structure implies the composition of funds raised from various sources broadly classi­fied as debt and equity. It may be defined as the proportion of debt and equity in the total capital that will remain invested in a business over a long period of time. Capital structure is concerned with the quantitative aspect. A decision about the proportion among these types of securities refers to the capital structure decision of an enterprise.

Importance of Capital Structure:

Decisions relating to financing the assets of a firm are very crucial in every business and the finance manager is often caught in the dilemma of what the optimum proportion of debt and equity should be. As a general rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Capital structure is usually designed to serve the interest of the equity shareholders.

Therefore instead of collecting the entire fund from shareholders a portion of long term fund may be raised as loan in the form of debenture or bond by paying a fixed annual charge. Though these payments are considered as expenses to an entity, such method of financing is adopted to serve the interest of the ordinary share­holders in a better way.

Value Maximization:

Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.

Cost Minimization:

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.

Increase in Share Price:

Capital structure maximizes the company’s market price of share by increas­ing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.

Investment Opportunity:

Capital structure increases the ability of the company to find new wealth, creating investment opportunities. With proper capital gearing it also increases the confidence of sup­pliers of debt.

Growth of the Country:

Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.

Patterns of Capital Structure:

There are usually two sources of funds used by a firm: Debt and equity. A new company cannot collect sufficient funds as per their requirements as it has yet to establish its creditworthiness in the market; consequently they have to depend only on equity shares, which is the simple type of capital structure. After establishing its creditworthiness in the market, its capital structure gradually becomes complex.

A complex capital structure pattern may be of following forms:

  1. Equity Shares and Debentures (i.e. long term debt including Bonds etc.),
  2. Equity Shares and Preference Shares.
  3. Equity Shares, Preference Shares and Debentures (i.e. long term debt including Bonds etc.).

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