concept of capital structure.docx

8/18/2019 Concept of Capital Structure.docx

1/22

P a g e | 1

Concept of Capital Structure:

The relative proportion of various sources of funds used in a business is termed asfinancial 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. o it relates to the

arrangement of capital and e!cludes short-term borrowings. It denotes some degree

of permanency as it e!cludes short-term sources of financing.

Capital is the ma"or part of all kinds of business activities, which are decided by

the si#e,and nature of the business concern. Capital may be raised with the help of

various sources.If the company maintains proper and adequate level of capital, it

will earn high profit and they can provide more dividends to its shareholders.

Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that

make up capitali#ation. It is the mi! of different sources of long-term sources such

as equity shares, preference shares, debentures, long-term loans and retained

earnings. The term capital structure refers to the relationship between the variouslong-term source financing such as equity capital, preference share capital and debt

capital. $eciding the suitable capital structure is the important decision of the

financial management because it is closely related to the value of the firm.Capital

structure is the permanent financing of the company represented primarily by long-

term debt and equity.


2/22

P a g e | 2

Definition of Capital Structure

%ccording to the definition of James C. Van Horne, &The mi! of a firm’s

permanent long-term financing represented by debt, preferred stock, and common

stock equity'.

%ccording to the definition of Presana Chandra, &The composition of a firm’s

financing consists of equity, preference, and debt'.

%ccording to the definition of R.H. Wessel, &The long term sources of fund

employed in a business enterprise'.

!"ecti#es of Capital Structure

$ecision of capital structure aims at the following two important ob"ectives(

). *a!imi#e the value of the firm.

+. *inimi#e the overall cost of capital.

$orms of Capital Structure

Capital structure pattern varies from company to company and the availability of

finance.ormally the following forms of capital structure are popular in practice.

quity shares only.

quity and preference shares only.

quity and $ebentures only.

quity shares, preference shares and debentures.


3/22

P a g e | 3

$%&'&C%'( S)R*C)*R+

The term financial structure is different from the capital structure. /inancial

structure shows the pattern total financing. It measures the e!tent to which total

funds are available to finance the total assets of the business.

/inancial tructure 0 Total liabilities

1r

/inancial tructure 0 Capital tructure 2 Current liabilities.

The following points indicate the difference between the financial structure and

capital structure.

$inancial Structures Capital Structures

). It includes both long-term and short-

term sources of funds

). It includes only the long-term sources

of funds.

+. It means the entire liabilities side of the

balance sheet.

+. It means only the long-term liabilities

of the company.

3. /inancial structures consist of all

sources of capital.

3. It consist of equity, preference and

retained earning capital.

4. It will not be more important while

determining the value of the firm.

4. It is one of the ma"or determinations of

the value of the firm.


4/22

P a g e | 4

Components of Capital Structure

Capital structure involves different sources from which the required long-term

capital is collected by the company. It differs from financial structure.

Shareholders $unds -oned capital/

• quity Capital

• 5reference Capital

• 6etained arnings

0orroed $unds

• $ebentures

• Term 7oans

• $eposits

Shareholders $unds -ned Capital/

In components of capital structure, shareholder8s funds 9owned capital: means

funds provided or contributed by the owners. It is also known as owned capital or

ownership capital. ;arious constituents of owned capital are(

1. +2uit3 Capital

In components of Capital structure, equity share capital represents the ownership

capital of the company. It is the permanent capital and cannot be withdrawn during

the lifetime of the company. They are the real risk bearers, but they also en"oy

rewards. Their liability is restricted to their capital contributed. quity shares are

popular among the investing class. &quity Capital is also known as 81wnedCapital8 or 86isk Capital8 or 8;enture Capital.8'


5/22

P a g e | 5

4. Preference Capital

In components of capital structure, preference shareholders are also owners of the

firm, and they get preference regarding payment of dividends and repayment of

Capital. They are cautious investors. 5reference hares carry a stipulated dividend.

5reference hares are of different types such as(

Redeema!le and &on5Redeema!le,

Con#erti!le and &on5Con#erti!le,

Cumulati#e and &on5Cumulati#e preference shares.

6. Retained +arnings

In components of capital structure, instead of distributing all the profits to

shareholders by way of a dividend, the firm retains < keeps < saves a part of the

profit for self-financing. 6etained earnings constitute the sum total of those profits

which have been reali#ed over the years and have been reinvested in the business.

Thus, it is also known as self-financing or ploughing back of profits. Thus, it is

also known as self-financing or working back of profits.


6/22

P a g e | 6

0orroed Capital

=orrowed capital is the amount raised by way of loans or credit. ;arious parts of

borrowed capital are(

1. De!entures

In components of capital structure, debenture capital is a part of borrowed capital.

The creditors of the company are the debenture holders. $ifferent types of

debentures are issued for the convenience of investors.

4. )erm (oan

In components of capital structure, organi#ations can obtain long-term and medium

term loans from banks and financial institutions. /urther, banks advance loans in

> dollar. Term loans are repayable by installments. /or obtaining term loans,

collateral security has to be offered by the organi#ation.

6. Pu!lic Deposits

5ublic deposit means any money received by a non-banking company by way of

deposit or loan from the public, including employees, customers and shareholders

of the company other than in the form of shares and debentures. Companies prefer

this method as such deposits are unsecured. % company can accept public deposits

for a period of up to 3 years.


7/22

P a g e | 7

'DV'&)'7+S '&D D%S'DV'&)'7+S $

$%&'&C%&7 P)%&S

=oth debt and equity financing offer small businesses a number of advantages and

disadvantages. The key for small business owners is to evaluate their company8s

particular situation and determine its optimal capital structure. %n optimal capital

structure is one that strikes a balance between risk and return and ma!imi#es the

price of the stock while simultaneously minimi#ing the cost of capital.

'd#antages of De!t $inancing

The primary advantage of debt financing is that it allows the founders to retain

ownership and control of the company. In contrast to equity financing, debt

financing allows an entrepreneur to make key strategic decisions and also to keep

and reinvest more company profits. %nother advantage of debt financing is that it

provides small business owners with a greater degree of financial freedom than

equity financing. $ebt obligations are limited to the loan repayment period, after

which the lender has no further claim on the business, whereas an equity investor8s

claim does not end until his or her stock is sold. $ebt financing is also easy toadminister, as it generally lacks the comple! reporting requirements that

accompany some forms of equity financing. /inally, debt financing tends to be less

e!pensive for small businesses over the long term than equity financing. 1ver the

short term, however, debt financing is far more e!pensive.


8/22

P a g e | 8

Disad#antages of De!t $inancing

The main disadvantage of debt financing is that it requires a small business to

make regular monthly payments of principal and interest. ;ery young companies

often e!perience shortages in cash flow that may make such regular payments

difficult, and most lenders provide severe penalties for late or missed payments.

%nother disadvantage associated with debt financing is that its availability is often

limited to established businesses. ince lenders primarily seek security for their

funds, it can be difficult for unproven businesses to obtain loans without a personal

guarantee from one of the principals in the business.

'd#antages of +2uit3 $inancingThe main advantage of equity financing for small businesses, which are likely to

struggle with cash flow initially, is that there is no obligation to repay the money.

quity financing is also easier to acquire than debt financing for early-stage or

start-up businesses. quity investors seek growth opportunities, so they are often

willing to take a chance on a good idea. =ut debt financiers seek security, so they

usually require the business to have some sort of track record before they will

consider making a loan. %nother advantage of equity financing is that investorsoften prove to be good sources of advice and contacts for small business owners.

Disad#antages of +2uit3 $inancing

The main disadvantage of equity financing is that the founders must give up some

control of the business. If investors have different ideas about the company8s

strategic direction or day-today operations, they can pose problems for the

entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very comple! and e!pensive to administer. uch equity financing may require

complicated legal filings and a great deal of paperwork to comply with various

regulations. /or many small businesses, therefore, equity financing may necessitate

enlisting the help of attorneys and accountants.


9/22

P a g e | 9

$eatures f Capital Structure

% sound capital structure should possess the following features(

-i/ Ma8imum Return:

The financial structure of a company should be guided by clear- cut ob"ective. Its

ob"ective can be ma!imi#ation of the wealth of the shareholders or ma!imi#ation

of return to the shareholders.

-ii/ (ess Ris93:

The capital structure should represent a balance between different types of

ownership and debt securities. This is essential to reduce risk on the use of debt

capital.

-iii/ Safet3:

% sound capital structure should ensure safety of investment. It should be so

determined that fluctuations in the earnings of the company do not have heavy

strain on its financial structure.

-i#/ $le8i!ilit3:% sound capital structure should facilitate e!pansion and contraction of funds. The

company should be able to procure more capital in times of need and should be

able to pay all its debts when it does not require funds.


10/22

P a g e | 10


11/22

P a g e | 11

-#/ +conom3:

The capital structure should ensure the minimum costs of capital which in turn

would increase its ability to generate more wealth for the company.

-#i/ Capacit3:

The financial structure of a company should be d3mamic. It should be revised

periodically depending upon the changes in the business conditions. If it has

surplus funds, the company should have the capacity to repay its debt and reduce

interest obligations.

-#ii/ Control:

The capital structure of a company should not dilute the control of equity

shareholders of the company. That is why, convertible debentures should be issued

with great caution.


12/22

P a g e | 12

%mportance of Capital Structure:

The importance of designing a proper capital structure is e!plained below(

Value Ma8imiation:

Capital structure ma!imi#es 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 ma!imi#ed.

Cost Minimiation:

Capital structure minimi#es the firm’s cost of capital or cost of financing. =y

determining a proper mi! of fund sources, a firm can keep the overall cost of

capital to the lowest.

%ncrease in Share Price:

Capital structure ma!imi#es the company’s market price of share by increasing

earnings per share of the ordinary shareholders. It also increases dividend receipt

of the shareholders.


13/22

P a g e | 13

%n#estment pportunit3:

Capital structure increases the ability of the company to find new wealth- creatinginvestment opportunities. ?ith proper capital gearing it also increases the

confidence of suppliers of debt.

7roth of the Countr3:

Capital structure increases the country’s rate of investment and growth by

increasing the firm’s opportunity to engage in future wealth-creating investments.


14/22

P a g e | 14

Concept of ptimal Capital Structure:

very firm should aim at achieving the optimal capital structure and try to maintain

it. 1ptimal capital structure refers to the combination of debt and equity in total

capital that ma!imi#es the value of the company. %n optimal capital structure is

designated as one at which the average cost of capital is the lowest which produces

an income that leads to ma!imi#ation of the market value of the securities at that

income.

;ul9arni and Sat3aprasad defined optimum capital structure as @the one in

hich the marginal real cost of each a#aila!le method of financing is the

samender optimal capital structure the finance manager determines the proportion

of debt and equity in such a manner that the financial risk remains low.

d/ The advantage of the leverage offered by corporate ta!es is taken into account in

achieving the optimal capital structure.


15/22

P a g e | 15

e/ =orrowings help in increasing the value of company leading towards optimal

capital structure.

f/ The cost of capital reaches at its minimum and market price of share becomes

ma!imum at optimal capital structure.

)he main constraints in designing the optimum capital

structure are:

1. The optimum debt-equity mi! is difficult to ascertain in true sense.

4. The concept of appropriate capital structure is more realistic than the concept of

optimum capital structure.

6. It is difficult to find an optimum capital structure as the e!tent to which the

market value of an equity share will fall due to increase in risk of high debt content

in capital structure, is very difficult to measure.

=. The market price of equity share rarely changes due to changes in debt-equity

mi!, so there cannot be any optimum capital structure.

>. It is impossible to predict e!actly the amount of decrease in the market value of

an equity share because market factors that influence market value of equity share

are highly comple!.


16/22

P a g e | 16

Capital structure theories:

0asic assumptions:

• There are only two kinds of funds used by a firm i.e. debt and equity.

• Ta!es are not considered.

• The payout ratio is )AAB

• The firm’s total financing remains constant

• =usiness risk is constant over time

• The firm has perpetual life.

&et %ncome 'pproach -&%/

%ccording to this approach, the cost of debt and the cost of equity do not change

with a change in the leverage ratio. %s a result the average cost of capital declines

as the leverage ratio increases. This is because when the leverage ratio increases,

the cost of debt, which is lower than the cost of equity, gets a higher weightage in

the calculation of the cost of capital.

The formula to calculate the average cost of capital is as follows(

o 0 d 9=< 9=2:: 2 e 9


17/22

P a g e | 17


18/22

P a g e | 18

&et perating income 'pproach -&%/

%ccording to this approach(

• The overall capitalisation rate remains constant for all levels of financial

leverage

• The cost of debt also remains constant for all levels of financial leverage

• The cost of equity increases linearly with financial leverage

The formula to calculate the cost of capital is o0d9=


19/22

P a g e | 19

o 6ises beyond that level at an increasing rate.

MM 'pproach

%ccording to this approach, the capital structure decision of a firm is irrelevant.

This approach supports the 1I approach and provides a behavioural "ustification

for it

%dditional assumptions of this approach include(

• Capital markets are perfect. %ll information is freely available and there areno transaction costs

• %ll investors are rational

• /irms can be grouped into @quivalent risk classes’ on the basis of their

business risk

• There are no ta!es

This approach indicates that the capital structure is irrelevant because of the

arbitrage process which will correct any imbalance i.e. e!pectations will change

and a stage will be reached where further arbitrage is not possible.


20/22

P a g e | 20

%mportant $actors 'ffecting the Choice of

Capital Structure

>nder the capital structure, decision the proportion of long-term sources of capitalis determined. *ost favourable proportion determines the optimum capital

structure. That happens to be the need of the company because 5 happens to be

the ma!imum on it. ome of the chief factors affecting the choice of the capital

structure are the following(

-1/ Cash $lo Position:

?hile making a choice of the capital structure the future cash flow position should

be kept in mind. $ebt capital should be used only if the cash flow position is really

good because a lot of cash is needed in order to make payment of interest and

refund of capital.

-4/ %nterest Co#erage Ratio5%CR:

?ith the help of this ratio an effort is made to find out how many times the =IT is

available to the payment of interest. The capacity of the company to use debt

capital will be in direct proportion to this ratio.

It is possible that in spite of better IC6 the cash flow position of the company may

be weak. Therefore, this ratio is not a proper or appropriate measure of the capacityof the company to pay interest. It is equally important to take into consideration the

cash flow position.


21/22

P a g e | 21

-6/ De!t Ser#ice Co#erage Ratio5DSCR:

This ratio removes the weakness of IC6. This shows the cash flow position of the

company.

This ratio tells us about the cash payments to be made 9e.g., preference dividend,

interest and debt capital repayment: and the amount of cash available. =etter ratio

means the better capacity of the company for debt payment. Consequently, more

debt can be utilised in the capital structure.

-=/ Return on %n#estment5R%:

The greater return on investment of a company increases its capacity to utilise

more debt capital.

->/ Cost of De!t:

The capacity of a company to take debt depends on the cost of debt. In case the

rate of interest on the debt capital is less, more debt capital can be utilised and vice

versa.

-?/ $loatation Costs:

/loatation costs are those e!penses which are incurred while issuing securities

9e.g., equity shares, preference shares, debentures, etc.:. These include commission

of underwriters, brokerage, stationery e!penses, etc. Denerally, the cost of issuing

debt capital is less than the share capital. This attracts the company towards debt

capital.


22/22

P a g e | 22

-@/ )a8 Rate:

The rate of ta! affects the cost of debt. If the rate of ta! is high, the cost of debtdecreases. The reason is the deduction of interest on the debt capital from the

profits considering it a part of e!penses and a saving in ta!es.

/or e!ample, suppose a company takes a loan of Appp )AA and the rate of interest

on this debt is )AB and the rate of ta! is 3AB. =y deducting )A

concept of capital structure.docx

Documents