The assets of a company can be financed either by increasing the owners’ claims or the creditors’ claims. The owners claim increase when the firm raises funds by issuing ordinary shares or by retaining earnings; the creditors’ claims increase by borrowing. The various means of financing represent the financial structure or capital structure of a company.
The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserve and surplus (retained earnings). The company will have to plan its capital structure initially at the time of its promotion. Subsequently, whenever funds have to be raised finance investment, a capital structure decision is involved. Capital structure of a company refers to the mix of sources from where the long-term funds required in the business may be raised. A demand for raising funds generates a new capital structure a decision has to be made to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors, which will govern the decision at present. The company’s policies to retain or distribute earnings affect the owner’s claim. Shareholder’s equity position is strengthened by retention of earning. The debt equity mix has implications for the shareholder’s earnings and risk, which in turn will affect the cost of capital and the market value of the firm.
Patterns of the Capital Structure
In case of new company, the capital structure may be of any the following patterns:
- Capital Structure with equity shares only.
- Capital Structure with equity and preference.
- Capital Structure with equity and debentures.
- Capital Structure with equity, preference shares and debentures.
Debt is the liability on which interest has to be paid irrespective of the company profits. While equity consists of shareholder or owner’s funds on which payment of dividend depends upon the company’s profit. A high proportion of the debt content in the capital structure increases the risk and may lead to financial insolvency in adverse time. However, raising fund through debt is cheaper as compared to financing through shares. This because interest on debt is allowed as an expense for taxes purpose. Dividend is considered to be an appropriation of profits; hence payment on dividend does not result in any tax benefit to the company. This means if company, is in 50% tax bracket, pays interest at 12% on its debentures, the effective cost to it comes only 6% while if the amount is raised by 12% Preference Shares, the cost of raising the amount would be 12%. Thus raising the funds by borrowing is cheaper resulting in higher availability of profit for shareholders. This increases the earning per share of the company, which is the basic objective of the finance manager.
Optimum Capital Structure
A firm should try to maintain an optimum capital structure with a view of to maintain financial stability. The optimum capital structure is obtained when the market value per equity share is the maximum. It may be defined as that relationship of debt and equity securities which maximizes the value of a company’s share in the stock exchange. In case a company borrows and this borrowing helps in increasing the value of company’s share in the stock exchange, it can be said that the borrowing has helped the company in moving towards its optimum capital structure. In case, the borrowing results in fall in market value of the company’s equity shares, it can be said that the borrowing has moved the company from its optimum capital structure.
The objective of the firm should therefore be to select the financing or debt equity mix, which will lead to maximum value of the firm.
The following consideration will greatly help a finance manager in achieving his goal of optimum capital structure:
- Take advantage of favourable financial leverage.
- Take advantage of the leverage offered by the corporate taxes.
- Avoid a perceived high risk capital structure.