An Appropriate Capital Structure is that capital structure at that level of debt – equity proportion where the market value per share is maximum and the cost of capital is minimum. It is important for a company to have an appropriate capital structure.
Features of an Appropriate Capital Structure
- Return- The capital structure of the company should be most advantageous subject to other considerations it should generate maximum returns to the shareholders without adding cost to them.
- Risk- The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used otherwise its use should be avoided.
- Flexibility- The capital structure should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.
- Capacity- The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditor’s fixed charges and principle sum.
- Control- The capital structure should involve minimum risk of loss of control of the company. The owner’s of closely-held companies are particularly concerned about dilution of control.
Approaches to Establish an Appropriate Capital Structure
The following are the 3 most common approaches to decide about a firm’s appropriate capital structure:
- EBIT-EPS Approach- The EBIT-EPS analysis is an important tool in the hands of the financial manager to get an insight into the firm’s capital structure management. He can consider the possible fluctuations in the EBIT and examine their impact on EPS under different financial plans. If the probability of earning a rate of return on the firm’s assets less than the cost of debt is insignificant, a large amount of debt can be used by the firm to increase the earnings per share. This may have a favorable effect on the market value per share. On the other hand, if the probability of earning a rate of return on the firm’s less than the cost of debt is very high, the firm should refrain from employing debt capital. It may, thus, be concluded that the greater level of EBIT & lower the probability of downward fluctuation, the more beneficial is to employ debt in the capital structure. However, it should be realized that the EBIT-EPS is a first step in deciding about a firm’s capital structure.
- Cost of Capital and Valuation Approach- The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by the shareholders than the debt-holders. In case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest whether it makes profits or not. The loan of debt-holders is returned within a prescribed period, while shareholders will have to share the residue only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The preference share capital is also cheaper than equity capital, but not as cheap as debt.
- Cash Flow Approach- One of a feature of a sound capital structure is conservatism. Conservatism does not mean employing no debt or small amount of debt. Conservatism is created by the use of debt or preference capital in the capital structure and the firm’s ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividends, and the principal, and they depend on both the amount of loan securities and the terms of payment. The amount of fixed charges will be high if employs a large amount of debt or preference capital with short-term maturity. The company expecting larger & stable cash inflows in the future can employ a large amount of debt in their capital structure.
One important ratio which should be examined at the time of planning the capital structure is the ratio of net cash inflows to fixed charges (debt- servicing ratio). It indicates the number of times the fixed financial obligations are covered by the net cash inflows generated by the company. The greater the coverage, the greater is the amount of debt a company can use.