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A company generally raises finance by issuing two kinds of securities viz. The ownership securities consist of preference shares and equity shares. Financing decisions are also called as the Capital Structure decision of the firm. The capital structure of a firm shows as to how the total capitalization of the firm is formed?

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. 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 project will be financed 20% by the common stock, 10% by the preferred stock, and the rest by the debt.

The decision to distribute or reinvest the company’s earnings influences equity or owners’ claim. Recapitalization of capital structure means redesigning the capital structure of company in accordance with business needs and changing conditions. It means changing the proportion of debt and equity from time to time to suit the requirements. The same to quote, Ezra, optimum leverage is that mix of debt and equity which will maximise the market value of the company and minimise the company’s overall cost of capital.

Capital structure refers to the combination of funds from different sources of finance. Company can arrange funds through equity share capital, retained earnings, preference share capital and long term debts. The market value of a leveraged and unleveraged firm will be the same if profits and future earnings are the same.

Components of Capital Structure

R.R. Wessel defines, ‘Capital structure is frequently used to indicate the long term sources of funds employed in a business enterprise’. VS International Ltd., has a capital structure comprising Rs.5,00,000 each share of Rs.10. The firm wants to raise an additional Rs.2,50,000 for expansion programme.

It refers to the expenses of a firm incurred during the process of public issue. Cost of flotation of debt is comparatively less when compared to the cost of flotation of equity. One should try to reduce this cost by a proper mix of debt and equity in the capital structure.

If the firm is able to earn an operating profit at Rs.80,000 after additional investment and 50 per cent tax rate. Calculate EPS for all four alternatives and select the preferable financial plan. Hence, there is utmost need of designing an appropriate capital structure. However, the use of debt in capitalisation will depend on expected profits of the firm. Financial risk factor is involved in the use of debt in the total capital of a firm. If profits are low, lower proportion of debt should be used so that interest burden on the firm does not pose a threat to the existence of the firm.

When a company exchanges one type of financing for another—such as taking on debt to buy back stock shares—that is known as recapitalization. A business can recapitalize by essentially exchanging debt for equity. It can acquire more debt—either by issuing corporate bonds or by taking on a business loan—and then use that leverage to purchase back some of its equity in the form of a share buyback. For instance, debt includes traditional business loans, but it also includes any supplier credit the business receives. The financial structure of a firm comprises the various ways and means of raising funds.’ In other words, financial structure includes all long-term and short-term liabilities.

The benefits are more when a firm uses debt as a source of finance, due to cheap and the interest is tax deductible source. Use of debt can be used to maximise shareholders’ wealth only when a firm has a high level of operating profit . EBIT-EPS analysis is one way to study the relation between earnings per share and various possible levels of operating profit , under various financial plans. A firm can use debt in a larger proportion in the capital structure of a firm, if the level of expected profits is high. Otherwise, debt should be used in small proportion in the capital of a firm.

In other words, capital structure represents in what proportion the total amount of capitalisation is divided in different securities. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital . Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders.

It includes capital structure in itself.Capital structure, in a broader sense, is an aspect of capitalization. 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 capital structure definition permanent financing of a firm. It is composed of long-term debt, prefer­ence share capital and shareholders’ funds. Capital Structure is a specific combination of debt and equity of a company required to fund its overall growth and operations.

Capital structure by industry

But companies that become too highly leveraged can lose their attractiveness to all but the most aggressive investors. A company’s capital structure points out how its assets are financed. When a company finances its operations by opening up or increasing capital to an investor , it avoids debt risk, thus reducing the potential that it will go bankrupt. But all owners of the company will have a proportional share of claim on the company’s earnings from that point on. Moreover, the owner may choose debt funding and maintain control over the company, increasing returns on the operations. In practice, the costs of capital have to be balanced with a capital structure that fits the business model.

The increasing proportion of debt will not dilute the control of the firm. The appropriate capital structure should maintain a proper mix of debt and equity capital so that management of the firm can function in the democratic way. It includes equity capital https://1investing.in/ including retained earnings and long-term debts. Thus, short-term liabilities should be excluded from the formulation of capital structure. In a simple way, capital structure is used to represent the proportionate relationship between debt and equity.

They’re usually salaries payable, expense payable, short term loans etc. Financial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period . To learn more, check out CFI’s business valuation course or FREE intro to corporate finance course. For instance, for a company involved in oil extraction or mining, it is not desirable to have a high debt ratio. However, in some industries such as banking or insurance, it is necessary to have a high amount of debt as a part of their capital structure. The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices.

• Its 1982 SEC rule 10b-18 permitted public firms to open-market repurchases of their own stock and made it simpler to manipulate capital structure.
• Hence the equity shares are also called ‘variable yield-bearing securities’ or ‘risk-bearing securities’.
• Debt-to-equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity.
• Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence.
• The capital structure of a firm should not pose risk to ownership control.

In exchange for this risk, investors expect a higher rate of return and, therefore, the implied cost of equity is greater than that of debt. Let us consider a rival company B which has $12, 00,000 in assets and ₹ 1, 00,000 in debt. Company B is highly leveraged as for every ₹1 of debt, the company has ₹11 in equity. This implies that the company has to focus on its returns to be able to finance its debts. The capital structure of the company is such that for every ₹ 2 of debt, the company is making ₹ 5.

Factors Determining Capital Structure

Capital structure can be a mixture of a company’s long-term debt, short-term debt, common stock, and preferred stock. A company’s proportion of short-term debt versus long-term debt is considered when analyzing its capital structure. Trading on equity becomes more important when expectations of shareholders are high. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis.

Corporate capital is the mix of assets or resources a company can draw on as a result of debt and equity financing. Capitalization change refers to a modification of a company’s capital structure — the percentage of debt and equity used to finance operations and growth. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. While equity capital cannot be refunded at any point which provides rigidity to plans.

It results in reduction in equity shares value for future investors. During inflationary conditions a company can adopt high gearing and can increase the rate of dividend for equity shareholders. In this period fixed interest bearing capital is used more and more as the profits increased considerably. The cost of capital refers to the expectation of the suppliers of funds. A firm should earn sufficient profits to repay the interest and installment of principal to the lenders. It is the maximum rate of return a firm should earn on its investment, so that market value of the shares of the company does not fall.

Capital market is moving from equity to debt and from debt to deep discount bonds. The finance manager must be careful in selecting the securities for capital structure. The company is said to be high-geared if a large part of its capital is raised through the issue of securities that carry a fixed rate of interest and dividends. The company is said to be low-geared if it is not required to pay interest and dividends at a fixed rate. Capital structure maximizes the company’s market price of share by increas­ing earnings per share of the ordinary shareholders.

Optimal capital structure

When the capital structure is composed of Equity Capital only or with Retained earnings, the same is known as Simple Capital Structure. We know that a firm obtains its requirement from various sources and invest the same also in various forms of assets. Businesses and governments use both of these markets for raising long-term funds that could go towards growth or maintenance. Under this approach, the JJ Company will have maximum value at a point where the WACC is at the minimum – that is, when the firm is 100% debt-financed. Capital structure refers to the mix between owner’s funds and borrowed funds. Preference Shares, Debentures Outstanding, and Long-term Loans are known as Fixed Cost-bearing securities or Non-risky-bearing securities.

It will increase the amount of debt and decrease the amount of equity on the balance sheet. Significant proportions that can be used to understand capital structure incorporates the debt ratio, capitalization ratio, and debt-to-equity ratio. Capital structure is the mix of sources of capital used in financing business operations. Understand the definition of capital structure and look into the four capital structure theories.

Equity Shares, Preference Shares and Debentures (i.e. long term debt including Bonds etc.). DebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state. VendorA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.