INTRODUCTION
Capital is the major part of all kinds of business activities, which are decided by
the size, 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 capitalization. It is the mix 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 various
long-term source financing such as equity capital, preference share capital and
debt capital. Deciding 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.
Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a
company refers to the composition or make up of its capitalization and it
includes all long-term capital resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s
permanent long-term financing represented by debt, preferred stock, and
common stock equity”.
According to the definition of Presana Chandra, “The composition of a
firm’s financing consists of equity, preference, and debt”.
According to the definition of R.H. Wessel, “The long term sources of
fund employed in a business enterprise”.
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial
structure shows the pattern total financing. It measures the extent to which total
funds are available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure
and capital structure.
Financial Structures Capital Structures
1. It includes both long-term and short-term sources 1. It includes only the long-term
of funds sources of funds.
2. It means only the long-term
2. It means the entire liabilities side of the liabilities of the company.
balance sheet. 3. It consist of equity,
preference and retained
3. Financial structures consist of all sources of earning capital.
capital. 4. It is one of the major
determinations of the value of
4. It will not be more important while the firm.
determining the value of the firm.
Example
From the following information, calculate the capitalization, capital structure
and financial structures.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000
Calculation of Capitalization
S. No. Sources Amount
1. Equity share capital 50,000
2. Preference share capital 5,000
3. Debentures 6,000
Capitalization 61,000
(i) Calculation of Capital Structures
S. No. Sources Amount Proporti
on
1. Equity share capital 50,000 76.92
2. Preference share capital 5,000 7.69
3. Debentures 6,000 9.23
4. Retained earnings 4,000 6.16
65,000 100%
(ii) Calculation of Financial Structure
S. No. Sources Amount Proporti
on
1. Equity share capital 50,000 71.42
2. Preference share capital 5,000 7.14
3. Debentures 6,000 8.58
4. Retained earnings 4,000 5.72
5. Bills payable 2,000 2.85
6. Creditors 3,000 4.29
70,000 100%
OPTIMUM CAPITAL STRUCTURE
Optimum capital structure is the capital structure at which the weighted average
cost of capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or
combination of debt and equity, that leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability
of finance. Normally the following forms of capital structure are popular in
practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.
FACTORS DETERMINING CAPITAL STRUCTURE
The following factors are considered while deciding the capital structure of the firm.
Leverage
It is the basic and important factor, which affect the capital structure. It uses the
fixed cost financing such as debt, equity and preference share capital. It is
closely related to the overall cost of capital.
Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a
firm. Normally long- term finance such as equity and debt consist of fixed cost
while mobilization. When the cost of capital increases, value of the firm will
also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
(a) Nature of the business: Use of fixed interest/dividend bearing finance
depends upon the nature of the business. If the business consists of
long period of operation, it will apply for equity than debt, and it will
reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a firm. If
the firm belongs to large scale, it can manage the financial requirements
with the help of internal sources. But if it is small size, they will go for
external finance. It consists of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the
considerations while dividing the capital structure of a firm. For
example, banking companies are restricted to raise funds from some
sources.
(d) Requirement of investors: In order to collect funds from different type
of investors, it will be appropriate for the companies to issue different
sources of securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long- term
funds from external sources. Hence the company must consider government policy regarding the
capital structure.