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The capital structure of a company is made up of debt and equity securities that
comprise a firms 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.
Capital is the major part of all kinds of business activities, which are decided by
the size,and nature of the business concern. Capital may be raised with the help of
various sources.If the company maintains proper and adequate level of capital, it
will earn high profit and they can provide more dividends to its shareholders.
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According to the definition of R.H. Wessel, The long term sources of fund
employed in a business enterprise.
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FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial
structure shows the pattern total financing. It measures the extent to which total
funds are available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and
capital structure.
Financial Structures
Capital Structures
2. It means the entire liabilities side of the 2. It means only the long-term liabilities
balance sheet.
of the company.
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Borrowed Funds
Debentures
Term Loans
Deposits
1. Equity Capital
In components of Capital structure, equity share capital represents the ownership
capital of the company. It is the permanent capital and cannot be withdrawn during
the lifetime of the company. They are the real risk bearers, but they also enjoy
rewards. Their liability is restricted to their capital contributed. Equity shares are
popular among the investing class. Equity Capital is also known as 'Owned
Capital' or 'Risk Capital' or 'Venture Capital.'
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2. Preference Capital
In components of capital structure, preference shareholders are also owners of the
firm, and they get preference regarding payment of dividends and repayment of
Capital. They are cautious investors. Preference Shares carry a stipulated dividend.
Preference Shares are of different types such as:
Redeemable and Non-Redeemable,
Convertible and Non-Convertible,
Cumulative and Non-Cumulative preference shares.
3. Retained Earnings
In components of capital structure, instead of distributing all the profits to
shareholders by way of a dividend, the firm retains / keeps / saves a part of the
profit for self-financing. Retained earnings constitute the sum total of those profits
which have been realized over the years and have been reinvested in the business.
Thus, it is also known as self-financing or ploughing back of profits. Thus, it is
also known as self-financing or working back of profits.
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Borrowed Capital
Borrowed capital is the amount raised by way of loans or credit. Various parts of
borrowed capital are:
1. Debentures
In components of capital structure, debenture capital is a part of borrowed capital.
The creditors of the company are the debenture holders. Different types of
debentures are issued for the convenience of investors.
2. Term Loan
In components of capital structure, organizations can obtain long-term and medium
term loans from banks and financial institutions. Further, banks advance loans in
US dollar. Term loans are repayable by installments. For obtaining term loans,
collateral security has to be offered by the organization.
3. Public Deposits
Public deposit means any money received by a non-banking company by way of
deposit or loan from the public, including employees, customers and shareholders
of the company other than in the form of shares and debentures. Companies prefer
this method as such deposits are unsecured. A company can accept public deposits
for a period of up to 3 years.
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(iii) Safety:
A sound capital structure should ensure safety of investment. It should be so
determined that fluctuations in the earnings of the company do not have heavy
strain on its financial structure.
(iv) Flexibility:
A sound capital structure should facilitate expansion and contraction of funds. The
company should be able to procure more capital in times of need and should be
able to pay all its debts when it does not require funds.
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(v) Economy:
The capital structure should ensure the minimum costs of capital which in turn
would increase its ability to generate more wealth for the company.
(vi) Capacity:
The financial structure of a company should be d3mamic. It should be revised
periodically depending upon the changes in the business conditions. If it has
surplus funds, the company should have the capacity to repay its debt and reduce
interest obligations.
(vii) Control:
The capital structure of a company should not dilute the control of equity
shareholders of the company. That is why, convertible debentures should be issued
with great caution.
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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 firms 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.
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Investment Opportunity:
Capital structure 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.
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MM Approach
According to this approach, the capital structure decision of a firm is irrelevant.
This approach supports the NOI approach and provides a behavioural justification
for it
Additional assumptions of this approach include:
Capital markets are perfect. All information is freely available and there are
no transaction costs
All investors are rational
Firms can be grouped into Equivalent risk classes on the basis of their
business risk
There are no taxes
This approach indicates that the capital structure is irrelevant because of the
arbitrage process which will correct any imbalance i.e. expectations will change
and a stage will be reached where further arbitrage is not possible.
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It is possible that in spite of better ICR the cash flow position of the company may
be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity
of the company to pay interest. It is equally important to take into consideration the
cash flow position.
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For example, suppose a company takes a loan of 0ppp 100 and the rate of interest
on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a
saving of in tax will take place (If 10 on account of interest are not deducted, a tax
of @ 30% shall have to be paid).
Therefore, the use of the debt capital can be made only to a limited level. If even
after this level the debt capital is used further, the cost of equity capital starts
increasing rapidly. It adversely affects the market value of the shares. This is not a
good situation. Efforts should be made to avoid it.