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Capital structure
Capital structure refers to the composition of long-term capital from sources like loans, reserves, shares, and bonds. It represents the relationship between different types of long-term capital. A proper capital structure maximizes firm value, minimizes costs, and increases share prices. It also allows firms to take advantage of new investment opportunities and supports country growth. Factors that affect capital structure include financial leverage, operating leverage, earnings per share, costs of different sources, growth and stability of sales, flexibility, nature and size of firm, cash flows, control, market conditions, asset structure, financing purpose, and period of finance. Advantages of debt include amplifying returns, greater control and flexibility, while equity provides flexibility in raising funds
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Capital structure
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- 2. MEANING OF CAPITALSTRUCTURE Capital structure represents the relationship among different kinds of long term capital. Normally, a firm raises long term capital through the issues of common shares, sometimes accompanied by preference shares. The share capital is often supplemented by debenture capital and others long term borrowed capital. The capital structure of a business enterprise is thus, related to the long-term financial requirements of the business.
- 3. DEFINITION According to Gerstenberg,“Capital structure of a company refers to the composition or make-up of its capitalization and it includes all long term capital resources viz loans, reserves, shares and bonds”.
- 4. The importance ofdesigning a proper capital structure is explained below: • Value Maximization: Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized. • Cost Minimization: Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest. • Increase in Share Price: Capital structure maximizes the company’s market price of share by increasing earnings per share of the ordinary shareholders. It also Importance of capital structure
- 5. • Investment Opportunity: Capitalstructure increases the ability of the company to find new wealth- creating investment opportunities. With proper capital gearing it also increases the confidence of suppliers of debt. • Growth of the Country: Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments. • Patterns of Capital Structure: There are usually two sources of funds used by a firm: Debt and equity. A new company cannot collect sufficient funds as per their requirements as it has yet to establish its creditworthiness in the in the market; consequently they have to depend only on equity shares, which is the simple type of type of capital structure. Importance continues…
- 6. FACTORS AFFECTING CAPITALSTRUCTURE 1. Financial leverage The use of long term fixed interest bearing debt and preference share capital along with with equity share capital is called financial leverage. 2. Operating Leverage This leverage depends on the operating fixed cost of the firm. If higher percentage of a firm’s firm’s total costs is fixed operating costs, the firm is said to have a high degree of operating operating leverage. Operating leverage measures the operating risk of a firm. Operating risk Operating risk is the variability of operating profit. 3. EBIT/EPS Analysis (Earning per share) Normally a financial plan that will give maximum values of EPS will be selected as the most most desirable mix. The greater the level of EBIT, the more beneficial it is to employee debt debt capital in capital structure. One of the important glaring structuring of EPS analysis is analysis is that it ignores risk.
- 7. FACTORS CONTINUES… 4. Costof capital It is necessary for the company to determine the cost of various sources of finance to establish establish the desirability of one source over the other. The impact of a financial decision is decision is measured in terms of overall cost of capital. 5. Growth and stability of sales The capital structure of a firm is highly influenced by the growth and stability of its sale. If sale. If the sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest repayment of debt. 6. Flexibility Capital structure of a firm should be flexible. It should be possible to raise additional fund, fund, whenever the need be, without much of difficulty and delay.
- 8. FACTORS CONTINUES… 7. Natureand size of a firm A public utility concern has different capital structure as compared to other manufacturing concerns. concerns. Public utility concerns may employ more of debt because of stability and regularity of their their earnings. On the other hand, a concern which cannot provide stable earnings due to the nature nature of its business will have to rely mainly on equity capital. 8. Cash flow analysis The capital structure of a firm should be so planned that it should be able to service its fixed charges charges under any reasonable predictable adverse circumstances. The companies expecting larger and larger and stable cash inflows in future can employ a large amount of debt in their capital structure. structure. Otherwise, it will be risky. 9. Control Ordinary or equity shareholders have voting rights. They are the owners of the firm and can exercise exercise control over its overall affairs. While preference shares do not have the voting right except except under special circumstances. But the use of too much debt will increase financial risk and may and may ultimately lead to bankrupcy, which means a complete loss of control.
- 9. FACTORS CONTINUES… 10. Marketability Theconditions in capital market are continuously changing. At one time the capital market favors the favors the debenture issue and at other time it readily accepts common share issues. Based on the the changing market sentiments, decision should be taken regarding raising the funds through debt or debt or equity. The available alternatives should be viewed in the light of both general capital market market conditions and internal conditions of the company. 11. Flotation Costs Flotation costs are incurred only when the funds are raised. Normally cost of floating a debt is less than less than the cost of floating an equity issue. It is not a very significant factor, but it should be considered in designing a capital structure. 12. Industry standard While designing the capital structure of a firm and the industrial position, the capital structure of of other similar risk-class firms should also be evaluated. This is because of the fact that in case a firm a firm follows a capital structure other than that of the similar firm in the same industry, it may not be not be accepted by the investors. Thus, while designing the capital structure of a firm, certain common common factors like nature, type and size, etc. are to be considered.
- 10. FACTORS CONTINUES… 13. Capitalmarket conditions Marketability means the ability of the firm to sell or market a particular type of security in a particular period of time. Marketability is considerably influenced by the constraints prevailing in the in the capital market. 14. Asset Structure The liquidity and the composition of assets should be kept in mind while selecting the capital structure. If fixed asset constitute a major portion of the total assets of the company, it may be possible possible for the company to raise more long term debts. 15. Purpose of financing If funds are required for a productive purpose, debt financing is suitable and the company should should issue debentures as interest can be paid out of the profits generated from the investment and if investment and if funds are required for permanent basis, equity capital is preferred. 16. Period of finance If the finance is required for limited period, debentures should be preferred to shares otherwise, equity otherwise, equity capital is appropriate.
- 11. ADVANTAGES • Amplifies Return-on-Equity Returnon equity, or ROE, is commonly used as a measure of business performance. It is the product of product of earnings, asset turnover and financial leverage or debt. The more leverage or debt you have you have in your capital structure, the more it amplifies your potential earnings. • Greater Control and Flexibility Debt financing allows you to keep full ownership over your business. With full ownership comes complete control. Equity financing is an investment in the ownership rights of the company. That is, That is, equity investors get a portion of earnings. If there are no earnings, equity investors aren't paid. aren't paid.
- 12. ADVANTAGES CONTINUES… • EquityAdvantages Capital structure also provides flexibility in raising funds. One advantage to equity financing for small small business is that it is generally more available than debt financing. If your business is unproven, unproven, lenders have nothing to base future cash flows on. • No liability to redeem Capital raised through equity shares does not have to be repaid until the company itself is would up, would up, this would be long-range planning in respect of the company. • Voting control right Equity shares entitle the owner to control and manage the company. Equity shares are greatly preferred by bold and risk-loving investors. Because owners of equity share are real owner of a company.
- 13. DISADVANTAGES • Signal ofcapitalization If promoter miscalculates in working out financial requirement of a company. The company company may land in a situation where it has a large surplus of capital. • High cost of fund raising As many bold and risk loving investors is always small. The company has to spend much time much time and money to rise equity capital. • Absence of close control In a company which is financed largely by equity shares. The number of equity shareholders shareholders will be quite large. As such it would become difficult to have effective management and control of its affairs due to wide diffusion of ownership.
- 14. DISADVANTAGES CONTINUES… • NoInvestment by Cautious Investors Cautious and risk bearing investors keep away from equity shares because of uncertainty of uncertainty of return and fear about safety of capital. Thus the company is denied the opportunity to raise funds from such investors whose number is admittedly quite large. • Dilution of trading on equity The company with both equity and preference shares can trade on the equity, but not to any any significant extent. • Absence of close control In case the company makes any default in paying dividend to preference shareholder, they they will earn the right to attend the general meeting and to vote on matters affecting their their interests.