Meaning and Concept of Capital Structure

The term ̳structure‘ means the arrangement of the various parts. So capital structure means
the arrangement of capital from different sources so that the long-term funds needed for the
business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-term
sources of funds in the total amount of capital which a firm should raise to run its business.

The capital structure is the particular combination of debt and equity used by a company to
finance its overall operations and growth. Debt comes in the form of bond issues or loans,
while equity may come in the form of common stock, preferred stock, or retained earnings.
Short-term debt such as working capital requirements is also considered to be part of the
capital structure.

Few definitions of capital structure given by some financial experts

―Capital structure of a company refers to the make-up of its capitalisation and it includes all
long-term capital resources viz., loans, reserves, shares and bonds.‖—Gerstenberg.

―Capital structure is the combination of debt and equity securities that comprise a firm‘s
financing of its assets.‖—John J. Hampton.

―Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-
term debts, preference share capital and equity share capital including reserves and
surplus.‖—I. M. Pandey.

Importance of Capital Structure

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A
properly designed capital structure ensures the determination of the financial requirements of
the firm and raises the funds in such proportions from various sources for their best possible
utilisation. A sound capital structure protects the business enterprise from over-capitalisation
and under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the
form of higher return to the equity shareholders i.e., increase in earnings per share. This can
be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of
debt capital in the capital structure which is the cheapest source of capital. If the rate of return
on capital employed (i.e., shareholders‘ fund + long- term borrowings) exceeds the fixed rate
of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders‘ wealth through
minimisation of the overall cost of capital. This can also be done by incorporating long-term
debt capital in the capital structure as the cost of debt capital is lower than the cost of equity
or preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt
capital because, at the time of poor earning, the solvency is disturbed for compulsory
payment of interest to .the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that,
according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be
diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,
payment of fixed interest charges and repayment of principal amount of debt in time) will
also increase. A sound capital structure protects a business enterprise from such financial risk
through a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the
higher proportion of debt in capital structure compels the company to pay higher rate of
interest on debt irrespective of the fact that the fund is available or not. The non-payment of
interest charges and principal amount in time call for liquidation of the company.

The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk
factor has an important bearing in determining the capital structure of a company and it can
be avoided if the project is financed by issues equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will be the risk
of variation in the expected earnings available to equity shareholders. If return on investment
on total capital employed (i.e., shareholders‘ fund plus long-term debt) exceeds the interest
rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not get
any return at all.

3. Cost of capital:

Cost of capital means cost of raising the capital from different sources of funds. It is the price
paid for using the capital. A business enterprise should generate enough revenue to meet its
cost of capital and finance its future growth. The finance manager should consider the cost of
each source of fund while designing the capital structure of a company.

4. Control:

The consideration of retaining control of the business is an important factor in capital

structure decisions. If the existing equity shareholders do not like to dilute the control, they
may prefer debt capital to equity capital, as former has no voting rights.

5. Trading on equity:

The use of fixed interest bearing securities along with owner‘s equity as sources of finance is
known as trading on equity. It is an arrangement by which the company aims at increasing
the return on equity shares by the use of fixed interest bearing securities (i.e., debenture,
preference shares etc.).

If the existing capital structure of the company consists mainly of the equity shares, the return
on equity shares can be increased by using borrowed capital. This is so because the interest
paid on debentures is a deductible expenditure for income tax assessment and the after-tax
cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate
of return on total capital employed exceeds the rate of interest on debt capital or rate of
dividend on preference share capital, the company is said to be trading on equity.

6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and
lending policies of financial institutions which change the financial pattern of the company
totally. Monetary and fiscal policies of the Government will also affect the capital structure
decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small company finds it
difficult to raise debt capital. The terms of debentures and long-term loans are less favourable
to such enterprises. Small companies have to depend more on the equity shares and retained
earnings.
On the other hand, large companies issue various types of securities despite the fact that they
pay less interest because investors consider large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different types of
investors will have to be kept in mind. For example, a poor or middle class investor may only
be able to invest in equity or preference shares which are usually of small denominations,
only a financially sound investor can afford to invest in debentures of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when
required. Flexibility provides room for expansion, both in terms of lower impact on cost and
with no significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds are
needed for long-term (say 10 years), it should be raised by issuing debentures or preference
shares. Funds should be raised by the issue of equity shares when it is needed permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and
certain earnings prefer debentures or preference shares and companies having no assured
income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital
structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are
required for manufacturing purposes, the company may procure it from the issue of long-
term sources. When the funds are required for non-manufacturing purposes i.e., welfare
facilities to workers, like school, hospital etc. the company may procure it from internal
sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is favourable. This is so because
the dividend payable on equity share capital and preference share capital are not deductible
for tax purposes, whereas interest paid on debt is deductible from income and reduces a
firm‘s tax liabilities. The tax saving on interest charges reduces the cost of debt funds.
Moreover, a company has to pay tax on the amount distributed as dividend to the equity
shareholders. Due to this, total earnings available for both debt holders and stockholders is
more when debt capital is used in capital structure. Therefore, if the corporate tax rate is high
enough, it is prudent to raise capital by issuing debentures or taking long-term loans from
financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate
cash inflows. It analyses solvency position and the ability of the company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered while planning the
capital structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT
is high from EPS point of view, debt financing is preferable to equity. If ROI is less than the
interest on debt, debt financing decreases ROE. When the ROI is more than the interest on
debt, debt financing increases ROE.

Optimal Capital Structure

Optimal capital structure is a financial measurement that firms use to

determine the best mix of debt and equity financing to use for
operations and expansions. This structure seeks to lower the cost of
capital so that a firm is less dependent on creditors and more able to
finance its core operations through equity.

In general, the optimal capital structure is a mix of debt and equity

that seeks to lower the cost of capital and maximize the value of the
firm. To calculate the optimal capital structure of a firm, analysts
calculate the weighted average cost of capital (WACC) to determine
the level of

risk that makes the expected return on capital greater than the cost of
capital.
Risk-return tradeoff

THE DYNAMICS OF RISK-RETURN TRADEOFF

The graph below is a Risk-Return Trade off the graph. It shows the
relationship between these two variables while making an investment.

LOW RISK
The bottom-left corner of the graph shows that there is low return for
low-risk financial instruments. Government-issued bonds, for
instance, US Treasuries, are considered to be the lowest risk financial
instruments because they are backed up by the federal government.
But due to the relatively non-speculative nature of the bonds, they
have low returns than bonds issued by corporations. In fact, while
assessing the expected return of instruments, the return on
government bonds is considered to be the risk-free rate.
HIGH RISK
As we move along the upward sloping line in the graph, the risk rises
and so does the potential return. This is understandable as investors
parting with their money for riskier assets would demand better
returns than a risk-free security; else they have no reason to take that
risk. This is the reason why the bonds issued by governments and
corporations for the same duration have different yields as with
corporate bonds, there is also a default risk priced into them which is
not the case with federal bonds.