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Capital Structure Definiation

Capital structure refers to the mix of long-term debt and equity used to finance a company's assets. It includes instruments like long-term debt, preferred stock, and common equity. The appropriate capital structure balances the costs and benefits of different financing sources to maximize the firm's value. It is an important financial decision as the mix of debt and equity can impact the company's risk level, financing costs, and share price.

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50 views6 pages

Capital Structure Definiation

Capital structure refers to the mix of long-term debt and equity used to finance a company's assets. It includes instruments like long-term debt, preferred stock, and common equity. The appropriate capital structure balances the costs and benefits of different financing sources to maximize the firm's value. It is an important financial decision as the mix of debt and equity can impact the company's risk level, financing costs, and share price.

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ahmad
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© © All Rights Reserved
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Capital Structure: Concept,

Definition and Importance


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“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.

Concept of Capital Structure:


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.

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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.

Various authors have defined capital structure in different ways.

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Some of the important definitions are presented below:


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:


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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.

The importance of designing a proper capital structure is


explained below:
Value Maximization:
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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:


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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:
i. Equity Shares and Debentures (i.e. long term debt including Bonds
etc.),

ii. Equity Shares and Preference Shares,

iii. Equity Shares, Preference Shares and Debentures (i.e. long term
debt including Bonds etc.).
However, irrespective of the pattern of the capital structure, a firm
must try to maximize the earnings per share for the equity
shareholders and also the value of the firm.

Value of Firm:

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