Capital Structure | Meaning, Importance, Determinants | Optimum Capital Structure

An enterprise can be raised either through ownership securities or creditorship securities. Equity shares and preference shares represent ownership securities. Bonds, debentures represent creditorship securities.

What is Capital Structure?

Capital structure refers to the “Make up of a firm’s capitalization”, It means the mix of different sources of long-term funds. Every business enterprise must have a proper mix of both these type of securities. An effective combination of ownership and creditorship securities indicates that the cost and risk are minimum.

Capital structure is the particular combination of debt, equity and other sources of finance that it uses to fund its long term financing. Capital structure of an organization reflects the overall investment and financing strategy of the firm. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Financial leverage is the extent to which fixed-income securities (debt) are used in a firm’s capital structure. If a high percentage of a firm’s capital structure is in the form of debt, then the firm is said to have a high degree of financial leverage.

Importance of capital structure

1. Capital Structure reflects the firm’s financial and investment planning.

2. Capital Structure indicates the risk zone of the firm.

3. Capital Structure acts as a tax planning tool.

4. Capital Structure helps to improve the image and reputation of the firm.

Factors Determining the Capital Structure

Some of the factors that determine the capital structure of an organization are as follows:

1. Trading on Equity

A company can raise funds by issuing shares or debentures. Debentures carry a fixed rate of interest. Interest has to be paid whether the company earns profit or not. Preference shares are eligible for fixed rate of dividend. But the payment of dividend depends on the profit earned by the company.

A company is said to be trading on equity if the rate of return on the total capital employed (shareholders funds plus long term borrowed funds) is more than the rate of interest on debentures or rate of dividend on preferences shares. Trading on equity is beneficial to those companies which have stability in their earnings.

Hence, the pattern of capital still depends on whether the company is trading on equity or not.

2. Retaining control

The preference shareholders and debenture shareholders cannot exercise control in the functioning of the company. So if the promoters are interested in retaining their control in the affairs of the company, then they must opt for preference shares or debentures.

3. Nature of Enterprise

Business organizations which have stability in their earnings or if they enjoy monopoly in the sales of their products can opt for preference shares/debentures. Since the organization enjoy stable earning, they can pay the interest on debenture or fixed rate of dividend regularly. But if the earnings are irregular, then the company must opt for equity capital. It must issue shares to raise fund.

4. Purpose of financing

If the funds are required for productive purpose, then the company can raise funds through issue of debenture, say for example, installing a plant and machinery is a productive purpose. By installing machines, the company can increase the production and sale of goods. Through sale of goods, the company can earn additional earnings and pay the interest to debenture holders.

On the other hand, if the purpose of finance is for a social cause like improving the welfare facilities for workers, the company must raise funds through issue of shares. The social purpose is not going to bring returns immediately to the concern.

5. Market sentiment

The market sentiment also determines the capital structure. If people want to play safe in the capital market, then funds can be raised by the company through issue of debentures. On the other hand, if people are interested in earning speculative income, then funds can be raised through issue of shares.

6. Government policies

Government Policies have a great influence on the capital structure of a company. If there is a change in the lending policy of the Government, then the capital structure is also decided according to the policies of the government.

7. Taxation Purpose

Interest payable on debt is deductible for tax purposes. Hence, debt capital is considered cheaper than equity capital.

8. Financial flexibility

A firm can rely on debt capital, if it can arrange finance on reasonable terms under adverse conditions. Flexibility in raising finance will be influenced by the economic environment (availability of savers and interest rates) and the financial position of the business.

9. Managerial style

The amount of funds to be borrowed depends on managers approach to finance risk. If the managers are conservative in nature, they usually try to keep the debt equity ratio low.

10. Business risk

If the nature of business is more risky, then the firm has to depend more on equity capital. If the income is not stable, then it is difficult for the firm to pay interest on the borrowed capital promptly. In such circumstances equity capital must be preferred than debt capital.

11. Expansion

Companies which prefer to expand its business can depend on borrowed capital. As the additional funds are utilized, business would fetch good returns in future. The additional profits earned by the company can be enjoyed by the existing shareholders.

12. Statutory restrictions

Raising funds through shares, debentures or loans depends on the statutory restrictions. A company cannot raise share capital more than the authorized limit. Similarly, there might be borrowing restriction in the Articles of Association.

Optimum Capital Structure

Optimum Capital Structure (OCM) refers to the relationship of debt and equity securities which maximize the value of the company’s share on the stock exchange. The composite cost of capital is the least at optimum capital structure.

Optimal capital structure can be defined as

that capital structure or combination of debt and equity that leads to the maximum value of the firm.

OCM maximizes the value of the company and hence the wealth of its owners and minimize the company’s cost of capital.

Features of Optimum Capital Structure

An optimum capital structure should have the following features:

1. Optimum capital structure should maximize the earning per equity share.

2. It should minimize the cost of financing.

3. The risk must be managed and it should not lead the company to insolvency.

4. It should be flexible and the composition of funds can be changed according to the requirements.

5. It should help the company to generate cash flow in future.

6. The company must be able to exercise control in its affairs.