Capital structure

Capital structure
Capital structure of a company refers to the mix of the long term finances used by the firm. It is the financing plan of the company.

Importance of the capital structure

The objective of any firm is to mix the permanent source of funds used by it in a manner that will maximize the companys market price. In other words company seeks to minimize their cost of capital. The proper mix of long term funds/ finance is referred as the Optimal capital structure. The capital structure decision is a significant managerial decision which influences the risk and return of the investors. The company will have to plan its capital structure at the time of promotion itself and also subsequently whenever the company needs to raise additional funds for various new projects.

Importance of the capital structure

Whenever the company needs to raise finance, it involves a capital structure decision because it has to decide the amount of finance to be raised as well as the source from which it is to be raised.

Process of capital structure decisions

Capital budgeting decision Need for long term sources of finance Capital structure decision

Existing capital structure

Dividend decision Debt equity mix

Effect on earnings per share

Effect on risks to be borne by investors

Effect on cost of capital

Optimal capital structure

Value of the company

Factors effecting the capital structure

Leverage : The use of fixed charges sources of funds such as preference shares, debentures and term loans along with the equity capital structure is described as financial leverage or trading on equity. The term trading on equity is used because it is the equity that is used as a basis for raising debt. Financial institutions while sanctioning long term loans insist that companies should generally have a debt equity ration of 2:1 for medium and large scale industries and 3:1 for small scale industries. A debt equity ratio of 2:1 indicates that for every 1 unit of equity the company has, it can raise 2 units of debt. The ratio is calculated using the formula = Debt/ Equity

Factors effecting the capital structure

Increased use of leverage increases the fixed commitments of the company in the form of interest and repayments and thus increases the risk of the equity shareholders as their returns are affected. Cost of capital Cash flows projections of the company Size of the company Dilution of control Floatation costs

Features of an optimal capital structure

An optimal capital structure should have the following features:
Profitability: The company should make maximum use of leverage at a minimum cost. Flexibility : The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise funds whenever the raises and also retire debts whenever it becomes too costly to continue with that particular source. Control: The capital structure should involve minimum dilution of control of the company. Solvency: The use of excessive debt threatens the solvency of the company.
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