Capital Structure
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 relations hip 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.
1 Meaning Of Capital 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.
Financial Structures
1. It
includes both long-term and short-term sources of funds
2. It
means the entire liabilities side of the balance sheet.
3.
Financial structures consist of all sources of capital.
Capital Structures
It
includes only the long-term sources of funds.
It means
only the long-term liabilities of the company.
It
consist of equity, preference and retained earning capital.
It is one
of the major determinations of the value of the firm.
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 fir m.
2 Objectives of Capital Structure
Decision
of capital structure aims at the following two important objectives:
1.
Maximize the value of the fir m.
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.
o Equity
shares only.
o Equity
and preference shares only.
o Equity
and Debentures only.
o Equity
shares, preference shares and debentures.
3 Factors Determining Capital structure
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 fir m must take careful steps to reduce the cost of
capital.
Nature of the business:
Use of fixed interest/divide nd 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.
Size of the company:
It also affects the capital structure of a firm. If the fir m 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.
Legal requirements :
Legal require me nts 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.
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.
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