Lecture No.

14 to 16
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.

Definition:
Capital structure of a company refers to the make-up of its capitalization 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:

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. 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.
5. 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.
6. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business to be
diluted.
7. 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.

Features of an Optimal Capital Structure:

1. Simplicity:
All businessmen are not educated. A complicated capital structure may not be understood by
all; on the contrary it may raise suspicions and create confusion. A capital structure must be
as simple as possible.
2. Profitability:
An optimum capital structure is one which maximises earning per equity share and
minimizes cost of financing.
3. Solvency:
In a sound capital structure, content of debt will be a reasonable proportion of the total
capital employed in the business. As a result, it has minimum risk of becoming insolvent.
4. Flexibility:
The capital structure of a firm should be such that it can raise funds as when required.
5. Conservatism:
The debt content in the capital structure of a firm should be within its borrowing limits. It
should be free from the risk of insolvency.
6. Control:
The capital structure should be designed in a such a way that it involves minimum risk of
loss of control of the firm.
7. Optimal debt-equity mix:
Optimal debt-equity mix in the capital structure of a company would be that point where the
weighted average cost of capital is minimum. Optimum debt- equity proportion establishes
balance between owned capital and debt capital. The firm should be cautious about the
financial risk associated with the maximum utilisation of debt.
8. Maximisation of the value of the firm:
An optimum capital structure makes the value of the firm maximum.

Factors influencing 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.).
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. 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.
9. 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.
10. Provision for future:
The provision for future requirement of capital is also to be considered while planning the
capital structure of a company.