In finance, capital structure states the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is formerly the composition or 'structure' of its liabilities. E.g. a firm that sells Rs.20 billion in equity and Rs.80 billion in debt is said to be 20% equity-financed and 80% debt financed. 

Capital Structure defined as

The term capital structure is used to denote the proportionate relationship between debt and equity. 

The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Conventionally, short-term borrowings are excluded from the list of methods of financing the firm’s capital expenditure. 

Questions while Making the Financing Decision 

  • How should the investment project be financed? 
  • Does the way in which the investment projects are financed matter? 
  • How does financing affect the shareholders‟ risk, return and value? 
  •  Does there exist an optimum financing mix in terms of the maximum value to the firm’s shareholders? 
  •  Can the optimum financing mix be determined in practice for a company? 
  •  What factors in practice should a company consider in designing its financing policy? 

Features of an Appropriate Capital Structure 

Capital structure is that capital structure at that level of debt – equity proportion where the market value per share is maximum and the cost of capital is minimum.  

Appropriate capital structure should have the following features:

  • Profitability / Return 
  • Solvency / Risk 
  • Flexibility 
  • Conservation / Capacity 
  • Control 

Determinants of Capital Structure 

  • Seasonal Variations 
  • Tax benefit of Debt 
  • Flexibility 
  • Control 
  • Industry Leverage Ratios 
  • Agency Costs 
  • Industry Life Cycle 
  • Degree of Competition 
  • Company Characteristics 
  • Requirements of Investors 
  • Timing of Public Issue 
  • Legal Requirements 

Patterns / Forms of Capital Structure 

Following are the forms of capital structure: 

  • Complete equity share capital; 
  • Different proportions of equity and preference share capital; 
  • Different proportions of equity and debenture (debt) capital and Different proportions of equity, preference and debenture (debt) capital.

Features of an Appropriate Capital Structure 

  • Profitability 
  • Solvency 
  • Return   
  • Risk   
  • Flexibility   
  • Capacity 
  • Control 
  • Conservatism 

financial management

May 24, 2017