The capital structure of a company refers to the mix of long-term financing used. The objective is to minimize costs while maximizing the company's value. An optimal capital structure balances factors like leverage, costs of capital, cash flows, company size, and control. It allows for profitability, flexibility, minimal control dilution, and maintains solvency.
The capital structure of a company refers to the mix of long-term financing used. The objective is to minimize costs while maximizing the company's value. An optimal capital structure balances factors like leverage, costs of capital, cash flows, company size, and control. It allows for profitability, flexibility, minimal control dilution, and maintains solvency.
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The capital structure of a company refers to the mix of long-term financing used. The objective is to minimize costs while maximizing the company's value. An optimal capital structure balances factors like leverage, costs of capital, cash flows, company size, and control. It allows for profitability, flexibility, minimal control dilution, and maintains solvency.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
Capital structure Capital structure of a company refers to the mix of the long term finances used by the firm. It is the financing plan of the company.
Importance of the capital structure
The objective of any firm is to mix the permanent source of funds used by it in a manner that will maximize the companys market price. In other words company seeks to minimize their cost of capital. The proper mix of long term funds/ finance is referred as the Optimal capital structure. The capital structure decision is a significant managerial decision which influences the risk and return of the investors. The company will have to plan its capital structure at the time of promotion itself and also subsequently whenever the company needs to raise additional funds for various new projects.
Importance of the capital structure
Whenever the company needs to raise finance, it involves a capital structure decision because it has to decide the amount of finance to be raised as well as the source from which it is to be raised.
Process of capital structure decisions
Capital budgeting decision Need for long term sources of finance Capital structure decision
Existing capital structure
Dividend decision Debt equity mix
Effect on earnings per share
Effect on risks to be borne by investors
Effect on cost of capital
Optimal capital structure
Value of the company
Factors effecting the capital structure
Leverage : The use of fixed charges sources of funds such as preference shares, debentures and term loans along with the equity capital structure is described as financial leverage or trading on equity. The term trading on equity is used because it is the equity that is used as a basis for raising debt. Financial institutions while sanctioning long term loans insist that companies should generally have a debt equity ration of 2:1 for medium and large scale industries and 3:1 for small scale industries. A debt equity ratio of 2:1 indicates that for every 1 unit of equity the company has, it can raise 2 units of debt. The ratio is calculated using the formula = Debt/ Equity
Factors effecting the capital structure
Increased use of leverage increases the fixed commitments of the company in the form of interest and repayments and thus increases the risk of the equity shareholders as their returns are affected. Cost of capital Cash flows projections of the company Size of the company Dilution of control Floatation costs
Features of an optimal capital structure
An optimal capital structure should have the following features: Profitability: The company should make maximum use of leverage at a minimum cost. Flexibility : The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise funds whenever the raises and also retire debts whenever it becomes too costly to continue with that particular source. Control: The capital structure should involve minimum dilution of control of the company. Solvency: The use of excessive debt threatens the solvency of the company. 8