What is Capital Structure
The most crucial component of starting a business is capital. It acts as the foundation of the company. Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined as the combination of equity and debt that is put into use by a company in order to finance the overall operations of the company and for its growth.
Types of Capital Structure
The meaning of Capital structure can be described as the arrangement of capital by using different sources of long term funds which consists of two broad types, equity and debt. The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans etc. These funds are raised for running the business.
Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different types
a) Retained earnings: Retained earnings are part of the profit that has been kept separately by the organisation and which will help in strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money which the company owners have invested at the time of opening the company or received from shareholders as a price for ownership of the company.
Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business. There are different forms of debt capital.
- Long Term Bonds: These types of bonds are considered the safest of the debts as they have an extended repayment period, and only interest needs to be repaid while the principal needs to be paid at maturity.
- Short Term Commercial Paper: This is a type of short term debt instrument that is used by companies to raise capital for a short period of time
Optimal Capital Structure
Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in maximising the value of a company in the market while at the same time minimises its cost of capital.
Capital structure varies across industries. For a company involved in mining or petroleum and oil extraction, a high debt ratio is not suitable, but some industries like insurance or banking have a high amount of debt as part of their capital structure.
Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total capital of the firm. It is also known as capital gearing. A firm having a high level of debt is called a highly levered firm while a firm having a lower ratio of debt is known as a low levered firm.
Importance of Capital Structure
Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the other factors that highlight the importance of capital structure
- A firm having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possesses. It will lead to a higher valuation in the market.
- A good capital structure ensures that the available funds are used effectively. It prevents over or under capitalisation.
- It helps the company in increasing its profits in the form of higher returns to stakeholders.
- A proper capital structure helps in maximising shareholder’s capital while minimising the overall cost of the capital.
- A good capital structure provides firms with the flexibility of increasing or decreasing the debt capital as per the situation.
Factors Determining Capital Structure
Following are the factors that play an important role in determining the capital structure:
- Costs of capital: It is the cost that is incurred in raising capital from different fund sources. A firm or a business should generate sufficient revenue so that the cost of capital can be met and growth can be financed.
- Degree of Control: The equity shareholders have more rights in a company than the preference shareholders or the debenture shareholders. The capital structure of a firm will be determined by the type of shareholders and the limit of their voting rights.
- Trading on Equity: For a firm which uses more equity as a source of finance to borrow new funds to increase returns. Trading on equity is said to occur when the rate of return on total capital is more than the rate of interest paid on debentures or rate of interest on the new debt borrowed.
- Government Policies: The capital structure is also impacted by the rules and policies set by the government. Changes in monetary and fiscal policies result in bringing about changes in capital structure decisions.
The concept of the Capital structure, along with the components and the factors that influence capital structure is discussed. To learn more about such important concepts, stay tuned to BYJU’S.
Also See:
- Difference Between Capital Structure and Financial Structure
Differences Between Debt and Equity Capital
Differences Between Equity Share Capital and Preference Share Capital
Mcqs on Capital Budgeting
FAQs
It acts as the foundation of the company. Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined as the combination of equity and debt that is put into use by a company in order to finance the overall operations of the company and for its growth.
What are the factors of capital structure? ›
Some main factors include the firm's cost of capital, nature, size, capital markets condition, debt-to-equity ratio, and ownership. However, these factors might help to choose an appropriate capital structure for a business, but checking all the side factors can help adopt more appropriate and accurate adaption.
What is capital structure and its importance? ›
What Is Capital Structure? Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Equity capital arises from ownership shares in a company and claims to its future cash flows and profits.
What are the four types of capital structure? ›
The types of capital structure are equity share capital, debt, preference share capital, and vendor finance. In addition, it ensures accurate funds utilization for business. The right capital structure level decreases the overall capital cost to the highest level. Also, it increases the public entity's valuation.
What are the factors to consider when designing an effective capital structure? ›
Answer: Factors responsible for capital structure designing are personal tax, corporate tax, bankruptcy, corporate governance, floatation, and other direct costs, ownership structure, signalling, government and other regulations, agency costs, macroeconomic variables, period of financing, stability of scale, choice of ...
What are the three 3 main parts in capital structure? ›
The Capital Structure is the mixture of debt, preferred stock, and common equity used by a company to fund its operations and purchase assets.
What are the factors of capital? ›
Capital is a factor of production that has been produced for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. Natural resources are the resources of nature that can be used for the production of goods and services.
What is an example of a capital structure? ›
For instance, a company may have a capital structure of 60% equity and 40% debt, indicating that 60% of its funds are raised through equity, and 40% through debt.
What is the basic goal of capital structure? ›
The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital).
What are the components of the capital structure? ›
Capital structure refers to a company's mix of capital—its debt and equity. Equity is a company's common and preferred stock plus retained earnings. Debt typically includes short-term borrowing, long-term debt, and a portion of the principal amount of operating leases and redeemable preferred stock.
Capital helps a company grow by providing the assets it needs to generate more revenue. A company that expands physically, adds new technologies or relocates might need additional cash to purchase new facilities or hire new personnel.
Why is financial structure important? ›
The financial structure will directly influence the cost of capital, risk exposure, and valuation of your business. Striking the right balance in financial structure is pivotal for optimizing a company's performance, ensuring sustainable growth, and maximizing shareholder value.
What is a strong capital structure? ›
What Is Optimal Capital Structure? The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility.
What is capital structure and its factors? ›
The meaning of Capital structure can be described as the arrangement of capital by using different sources of long term funds which consists of two broad types, equity and debt. The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans etc.
What is the capital structure decision? ›
Capital structure decision is concerned with the sources of long term funds such as debt and equity capital. Capital structure is defined as the mix of various long term sources of funds broadly classified as debt and equity. Hence capital structure is also referred to as 'Debt Equity Mix' of a company.
What is the ideal capital structure? ›
The optimal capital structure of a company refers to the proportion in which it structures its equity and debt. It is designed to maintain the perfect balance between maximising the wealth and worth of the company and minimising its cost of capital.
What are the factors determining working capital structure? ›
Answer: Working capital, or networking capital, has several determinants, including nature and size of business, production policy, the position of the business cycle, seasonal business, dividend policy, credit policy, tax level, market conditions and the volume of businesses.
What are the variables of capital structure? ›
The dependent variable is the firm's capital structure proxied by total debt ratio, long-term debt ratio, and short-term debt ratio, while the independent variables are sales growth, firm size, profitability of firm, and tangibility ratio.
What is the capital structure composed of? ›
Capital Structure is a combination of financial instruments like equity shares, preference shares, long-term loans, debentures, bonds or retained earnings that a business uses to raise funds for its operations. These long-term options help firms carry out their economic activities to generate profits.
What are the factors that affect the cost of capital? ›
We identify four primary factors : general economic conditions, the marketability of the firm's securities (market conditions), operating and financing conditions within the company, and the amount of financing needed for new investments.
