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Capital Structure: Theory and Analysis

The document discusses capital structure and its importance in financing decisions for companies. It defines capital structure as the proportion of debt and equity that make up a company's total capital. Determining the optimal capital structure involves balancing the risks and returns of debt against equity. Several factors must be considered, including the company's profitability, ability to repay debt, and impact on earnings per share and firm value. There is no single optimal structure, as it depends on the specific industry and company characteristics. The document outlines different methods that have been suggested for calculating an optimal capital structure.

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Rashmi Kumari
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111 views4 pages

Capital Structure: Theory and Analysis

The document discusses capital structure and its importance in financing decisions for companies. It defines capital structure as the proportion of debt and equity that make up a company's total capital. Determining the optimal capital structure involves balancing the risks and returns of debt against equity. Several factors must be considered, including the company's profitability, ability to repay debt, and impact on earnings per share and firm value. There is no single optimal structure, as it depends on the specific industry and company characteristics. The document outlines different methods that have been suggested for calculating an optimal capital structure.

Uploaded by

Rashmi Kumari
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Capital Structure: Theory and

Analysis
Capital Structure
Financing decisions involve raising funds for the firm. It is concerned
with formulation and designing of capital structure or leverage. The
most crucial decision of any company is involved in the formulation of
its appropriate capital structure. The best design or structure of the
capital of a company helps the management to achieve its ultimate
objectives of minimising overall cost of capital, maximising profitability
and also maximising the value of the firm.
The capital structure decision of a firm is concerned with the
determination of debt equity composition. Capital structure ordinarily
implies the proportion of debt and equity in the total capital of a
company. The term capital may be defined as the long – term funds of
the firm. Capital is the aggregation of the items appearing on the left
hand side of the balance sheet minus current liabilities.
In other words capital may be expressed as follows:
Capital = Total Assets – Current Liabilities.
Further, capital of a company may broadly be categorised into equity
and debt. The total capital structure of a firm is represented in the
following figure:
Total Capital

Equity Capital Debt Capital

Equity Share Capital Term Loans


Preference Share Capital Debentures
Share Premium Deferred Payments Liabilities
Retained Earnings Other Long term Debt

Established companies generally have track record of their profit earning


capacity, which helps them to create their creditworthiness. The lenders
feel safe to invest their funds in such companies. Thus, there is ample
scope for this type of companies to collect debt. But a company cannot
freely i.e. without having any limit. The company must have to chalk out
a plan to collect a debt in such a way that the acceptance of debt
becomes beneficial for the company in terms of increase in EPS,
profitability and value of the firm.
If the cost of capital is greater than the return, it will have an adverse
effect on company’s profitability, value of the firm and its EPS.
Similarly, if company is unable to repay the debt within the scheduled
period it will affect the goodwill of the company in the credit market and
consequently may create problems in future for collecting further debt.
Other factors remaining constant, the company should select its
appropriate capital structure with due consideration.
Capital structure involves a choice between risk and expected return.
The optimal capital structure strikes the balance between these risks and
returns and thus examines the price of the stock.

Significant variations with regard to capital structure can easily be


noticed among industries and firms within the same industry. So it is
difficult to generate the model capital structure for all business
undertakings. The following is an attempt to consolidate the literature on
various methods to suggested by researchers in arriving at optimal
capital structure.
Notations used:

 V = value of firm

 FCF = free cash flow

 WACC = weighted average cost of capital

 rs and rd are costs of stock and debt

 re and wd are percentages of the firm that are financed with


stock and debt.

Operating and Financial Leverages


The term leverage refers to the ability of a firm in employing long –
term funds having a fixed cost, to enhance returns to the owners. In other
words leverage is the employment of fixed assets or funds for which a
firm has to meet fixed costs or fixed rate of interest obligation
irrespective of the level of activities attained or the level of operating
profit earned.
Higher the leverage, higher the profits and vice – versa. But a higher
leverage obviously implies higher outside borrowings and hence riskier
if the business activity of the firm suddenly takes a dip. But a low
leverage does not necessarily indicate prudent financial

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