The capital structure decision

Capital structure represents the relationship among different kinds of long term capital. Normally, a firm raises long term capital through the issue of common shares,sometimes accompanied by preference shares.  The share capital is often supplemented by debenture capital and other long-term borrowed capital.

Definition

According to Gerestenberg “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”.

according to James C. Van Horne “The mix of a firm’s permanent long-term financing represented by debt,preferred stock,and common stock equity”.

The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.



Components of capital structure:

1. Owner’s capital:

Items are included in owner’s capital:

  • Equity shares: Equity shares are the fundamental and basic source for financing the activities of a business.
  • Preference shares: Those shares which carry following preferential rights are termed as preference shares:
  1. A preferential right as to the payment of dividend during the lifetime of a company.
  2. A preferential right as to the return of capital when the company is wound-up.
  • Retained earnings: Retained earning are considered to be the best source of internal financing . This type of financing is considered to be most convenient as no efforts are required to rise such finance.

2. Borrowed Capital:

  1. Debentures: A debenture is an acknowledgement of debt or loan raised by a company. Company has to pay interest to debenture holders at an agreed rate under contractual obligation.
  2. Term Loans: Term loans are provided by banks and other financial institutions which carry a fixed rate of interest for a period of three or more years.

Importance of capital structure:

1. To reduce the overall risk of company: When the company makes capital structure before actual getting money from money supplier it can do many adjustment for reducing its overall risk. At initial level, the company will try to keep or avoid debt content in its capital structure.

2. To adjustment according to business environment: Proper planning of capital structure of future sources will be helpful to enlarge the area for getting money.In finance it is called Manoeuvrability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure.

3. Idea generation of new source of fund: Good planning of capital structure will make versatile to finance manager for getting money from new sources.

Factors effecting capital structure decision:

1. Economy characteristics: The major developments taking place in the economy affects the capital structure of firms.

2. Industry characteristics: The following characteristics  of the industry affect the capital structure decision of a firm: 1. Level of competition and 2. Life cycle of industry.

3. Company characteristics:

    1. size of business
    2. age of company
    3. stability of earning
    4. form of organisation
    5. credit standing
    6. asset structure



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