CAPITAL STRUCTURE – AN OVERVIEW:

Capital structure is a term widely used in finance management. The main sources of finance include debt, equity and preference shares. Capital structure is defines as a proportion of these sources of finance in the total capital of business.

In other words, capital structure is concerned with decision making regarding the mix of debt, equity and debenture in the overall capital.

APPROPRIATE CAPITAL STRUCTURE:

Capital structure is said to be appropriate, when the combination of debt and equity will maximize the shareholders wealth and ultimately the value of firm. Shareholders wealth can be increased either by increasing revenues or decreasing cost. Thus, optimal capital structure is the one that strikes a balance between risk and return to achieve ultimate goal of maximizing wealth of shareholders.

FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE:

A capital structure is said to be optimal if it consists of the following features:

1. FLEXIBILITY:

The capital structure is said to be optimal, if it allows timely changes as per the need arises.

2. ENSURES SOLVENCY:

An appropriate capital structure should consist of an appropriate mix of debt and equity and ensures solvency of business under long run.

3. HELPS IN MAXIMIZING PROFITS:

The capital should be able to achieve to achieve the ultimate goal of organization i.e. maximization of profits either through increasing revenues or decreasing costs.

4. RETAINS CONTROL:

An optimal capital structure must ensure proper control for example the firm must have the control of utilizing more of debt until the situation demands raising funds through equity.

5. AVOID RESTRICTIONS:

A capital structure should not pose unnecessary restrictions on the business.

 

FACTORS EFFECTING CAPITAL STRUCTURE PLANNING:

Planning the capital structure of an organization is a challenging task. The managers are required to do a careful analysis of various sources of finance. But still there are certain factors directly or indirectly affect the capital structure planning of a firm. It includes:

  • Cost of capital:

The cost related to various sources of finance is an important factor affecting capital structure planning. The sources with low costs are preferred over the high cost sources.

  • Risk factor:

The risk factor is also important as the capital structure should be such that it should involve less risk to the firm.

  • Nature of business:

Those Businesses in which high amount of risk is involved, goes for equity as major source of finance while other businesses involving less amount of risk goes for debt financing.

  • Period of finance:

If the funds are required for long period, equity is preferred but if the funds are required for a shorter span of time, debts could be the choice.

  • Purpose of finance:

The purpose for which the funds are required also plays an important role. If the funds are required for some productive purpose, debts are preferred whereas if the funds are required for unproductive purpose, equity is the preference.

  • Asset structure:

The asset structure of a firm is another factor that affects the capital structure planning. If the majority of assets are fixed assets, the firm can finance through debts but if the majority of assets consist of liquid assets, the preferred source of finance is equity.

 

THEORIES OF CAPITAL STRUCTURE:

There are a number of theories that can help in order to understand the relationship between cost of capital, capital structure and the value of firm. These theories are as follows:

  • v  NET INCOME APPROACH
  • v  NET OPERATING INCOME APPROACH:
  • v  TRADITIONAL APPROACH
  • v  MODIGILANI & MILLER APPROACH

 

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