Capital structure is a business finance term that describes ‘the proportion of a company’s capital, or operating money, which is obtained through debt and equity or hybrid securities’. Debt consists of loans and other types of credit that is to be repaid in the future, usually with interest. Equity involves ownership interest in a corporation in the form of common stock or preferred stock. Equity financing does not involve a direct obligation to repay the funds which is in contrast to debt financing. Instead, equity investors are able to exercise some degree of control over the company as they become part-owners and partners in the business.
The goal of a company’s capital structure decision is to maximize the gains for the equity shareholders. The optimal capital structure is the one that maximizes the price of the stock and simultaneously minimizes the cost of capital thus striking a balance between risk and return.
A firm’s major decision is its financial decisions which can be analyzed in the theory of Corporate Capital Structure that is determined mainly by cost variables- equity, debt and bankruptcy risk and other potential variables such as growth are, profitability and operating leverage.
Features of a Sound Capital Structure
Capital structure is that level of debt-equity proportion where the market value per-share is maximum and the cost of capital is minimum. It should have the following features:
- Profitability/Return: Studies have shown that the relationship between debt-equity ratio and a firm’s profit margin is such that for a firm which prefers to finance its investments through self-finance are more profitable than firms which finance investment through borrowed capital, firms prefer competing with each other than cooperating and firms use their investment in fixed assets as a strategic variable to affect profitability.
- Solvency/Risk: Capital Structure of a firm indicates how much the company is leveraged by comparing what it owes to creditors and investors to what it owns. It reveals the degree to which the company’s management is willing to fund its operations with debt, rather than equity. Lenders are sensitive about this feature as a high debt-equity ratio will put their loans at risk of being unpaid.
- Flexibility: Flexibility is the ability to make decisions that the firm thinks are most apt even when others disagree. The level of flexibility the management can have depends on how the firm is financed. Debt offers little flexibility relative to equity. However, the flexibility offered by equity depends on the extent to which shareholders are inclined to agree with management’s strategic choices. The flexibility benefit of equity is high only when the share price is high.
- Conservation/Capacity: If a firm starts with a specific business risk, then the total risk associated with stock and debt is not affected by the capital structure. This is called ‘conservation of risk’. Risk is neither created nor destroyed. Debt capacity involves the assessment of the amount of debt that the organization can repay in a timely manner without forfeiting its financial viability.
- Control: The capital structure of a firm shows when control is allocated to only shareholders and when to others like creditors, or the management team. Generally the shareholders get control when the firm’s cash flow is sensitive. Also , debt value and firm value are negatively correlated when debt holders have veto power.