The 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.
Financing the firm’s assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital along with equity shares is called financial leverage or trading on equity. The long term fixed interest bearing debts is employed by a firm to earn more from the use of these sources than their cost so as to increase the return on owner’s equity. It is true that capital structure cannot affect the total earnings a firm but is can affect the share of earnings available for equity shareholders.
The capital structure decision can influence the value of the firm through the cost of capital and trading on equity or leverage. The optimal capital structure may be defined as “that capital structure or combination of debt and equity that leads to the maximum value of the firm.” Optimal capital structure maximizes the value of the company and hence the wealth of its owners and minimizes the company’s cost of capital. Thus, every firm should aim at achievement the optimal capital structure and then to maintain it.
The following considerations should be kept in mind while maximizing the value of the firm in achievement the goal of optimal capital structure:
- If the return on investment is higher than the fixed cost of funds, the company should prefer to raise funds having a fixed cost, such as debentures, loans and preference share capital. It will increase earnings per share and market value of the firm. Thus, a company should, make maximum possible use of leverage.
- When debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expenses in computation of tax. Hence, the effective cost of debt is reduced, called tax leverage. A company should, therefore, take advantages of tax leverage.
- The firm should avoid undue financial risk attached with the use of increased debt financing. If the shareholders perceive high risk in using further debt capital, it will reduce the market price of share.
An optimal capital structure should have the following features:
- Minimum Risk: An optimal capital structure should keep the total risk of the firm to the minimum level. It should not be a threat to the solvency of the company and should ensure a proper balance between business risk and financial risk.
- Maximum Profitability: An optimal capital structure should be the most profitable capital structure from the point of view of the equity shareholders. It should be that capital structure which will maximize the value of the equity shareholders.
- Minimum Dilution of Control: An optimal capital structure should involve minimum dilution of control of the company.
- Maximum Flexibility: The optimal capital structure should be flexible to be able to meet the changing conditions. It should have untapped borrowing powers which would enable the firm to raise additional capital funds whenever needed to finance profitable investment opportunities.