What is Capital Structure
“Capital structure decision is considered as one of the important decision to be taken by financial Managers.”
Capital structure is the combination of two words: Capital & Structure. The term capital refers to the funds raised from long-term sources of financing that covers long-term debt, preferred stock, and common equity. Primarily, the total capital employed in the firm is divided into components as debt capital and equity capital. On the other hand, structure refers to the composition or mix. Thus, the structure represents the parts or proportion of each component in total.
After defining the two words capital and structure separately, we can define the capital structure as the combination of long-term sources of fund used in the business. It represents a proportionate mix of various long-term sources of financing. The long-term sources of financing include long-term debt, preferred stock and common equity including retained earnings. In equation form, a capital structure can be shown as follows:
Capital Structure = Long-term debt + Preferred stock + Common equity
Capital structure decision falls under the financing decision of the firm. The financing decision of the firm involves the determination of financing need of the firm, identifying the sources of fund and deciding upon the proportionate mix of fund form different sources. Under the financing decision, the financial manager should assess what amount of capital is needed and which sources could be relied upon. The decision related to the determination of the proportionate mix of the long-term fund is the capital structure decision.
Based on the above explanation, the following conclusions can be drawn about the capital structure.
- The capital structure includes only the long-term sources of financing
- The capital structure shows the proportionate mix of different sources of long-term capital used in business.
Capital structure refers to the composition of permanent financing of the firm represented by long-term debt, preferred stock and common equity.
Financial Structure and Capital Structure
The two terms of financial structure and capital structure are frequently used in the context of corporate financial management. In above, we have defined only the capital structure. This section will define both the term financial structure and capital structure. In addition, we will explore the relationship between financial structure and capital structure.
Financial structure refers to the way the firm’s assets are financed with. It refers to the entire capital and liabilities side of the balance sheet. Thus, it encompasses all sources of financing that covers current liabilities, long-term debt, preferred stock, and common equity. The financial structure of a firm in equation form can be written as follows:
Financial structure = Current liabilities + Long-term debt + Preferred stock + Common equity
However, the capital structure includes, only the long-term sources of financing. Thus the capital structure is only a part of financial structure. The relationship between financial and capital structure can be expressed as follows:
Financial structure = Current liabilities + Capital Structure OR Capital structure = Financial structure - Current liabilities
Financial structure refers to the composition of all sources of financing.
Capital structure refers to only the long-term sources of financing.
Capital structure is only the part of financial structure.
You May Like:
Concept of Optimal Capital Structure
Every firm has its own capital structure. However, all capital structure cannot be considered as an optimal capital structure. Optimal capital structure refers to the combination of a mix of debt, preferred stock and common equity that maximizes the total value of the firm or minimizes the weight average cost of capital. It is also known as a target capital structure.
Optimal capital structure is the mix of long-term debt, preferred stock and common equity that minimizes the weighted average cost of capital and maximizes the total value of the firm.
There are significant variations in the capital structure of different industries and different companies. The capital structure varies not only among the industries but it also varies greatly across the different companies within the same industry. Designing the optimal structure is a formidable task. Therefore, the financial manager should be very much careful while designing the capital structure of the firm. The optimal capital structure should balance between risk and return to equity shareholders. The capital structure which helps to accomplish these objectives is called an optimal capital structure.
Firms may use a different capital structure. All capital structure cannot be considered as an optimal capital structure. To be optimal, the capital structure of the firm should have the following features.
- Minimization of Risk of Loss of Control
- Intensive Use
Significance of Optimal Capital Structure
Optimal capital structure has an instrumental role in the firm to achieve its shareholder’s wealth maximization objective. It provides flexibility in financing, minimizes dilution in control power of existing shareholders, enables to take tax advantages offered by the use of appropriate financial leverage.
- Optimal capital structure minimizes the weighted cost of capital.
- Optimal capital structure maximizes the worth of the firm.
- Optimal capital structure minimizes the financial risk by maintaining a sufficient amount of solvency.
- The flexibility feature of the optimal capital structure helps the firm to take the advantages of change in the market interest rate.
- The optimal capital structure protects form dilution in control of existing shareholders.
- Optimal capital structure enables the firm to take tax advantages offered by the use of appropriate financial leverage.
- The optimal capital structure makes possible for the intensive use of collected capital.
Goals of Capital Structure Management
Capital structure decision also aims to achieve certain goals. The overall goal of capital structure management is to determine the appropriate mix of debt and equity that will maximize market price per share or minimize the overall cost of capital of the firm. The capital structure management also aims to:
- Take the Advantage of Favorable Financial Leverage: The use of appropriate mix debt and equity makes the firm possible to get a higher return. If the firm employs a large amount of debt, it will increase the profitability to the shareholders.
- Take the Advantage of Debt Tax Shield: Interest paid on debt capital is the tax-deductible expenses. Thus, firms can get the tax benefit from the use of debt capital, which is not the case and common stockholders are paid out of after-tax income.
- Provide Flexibility in Capital Structure: The optimal capital structure takes into account both current and future need of the firm. Such consideration enhances the flexibility in financing the capital and makes the capital structure operational in the changing context of the business.
- Maintain the Control Power: Maintaining control is the prime focus of management. Management always wants to maintain control power over the firm. Issue of excess equity shares to a new investor may bring threats to the control power of existing shareholders. An optimal capital structure pays proper attention to this matter. Thus, it protects the existing shareholders from the dilution in their control position.