Page 128 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 7.1 Meaning of Capital Structure

The basic objective of financial management is to maximize the shareholders wealth. Therefore,
all financial decisions in any firm should be taken in the light of this objective.
Whenever a company is required to raise long-term funds the finance manager is required to
select such a mix of sources of finance that overall cost of capital is minimum (i.e., value of the
firm/wealth of shareholders is maximum). Mix of long-term sources of finance is referred as
“capital structure”.

Optimum Capital Structure

The capital structure is said to be optimum when the firm has selected such a combination of
equity and debt so that the wealth of firm (shareholder) is maximum. At this capital structure,
the cost of capital is minimum and market price per share is maximum.
It is very difficult to find out optimum debt and equity mix where capital structure would be
optimum because it is difficult to measure a fall in the market value of an equity shares on
account of Increase in risk due to high debt content in capital structure. Hence, in practice, the
expression “appropriate capital structure” is more realistic expression than ‘optimum capital
structure’.

Features of an Appropriate Capital Structure

1. Profitability: The most profitable capital structure is one that tends to minimize cost of
financing and maximize earning per equity share.

2. Flexibility: The capital structure should be such that company can raise funds whenever
needed.
3. Conservation: The debt content in the capital structure should not exceed the limit, which
the company can bear.
4. Solvency: The capital structure should be such that firm does not run the risk of becoming
insolvent.
5. Control: The capital structure should be so devised that it involves minimum risk of loss
of control of the company.

Self Assessment

Fill in the blanks:
1. Capital structure is referred as mix of ……………..sources of finance.
2. At …………….capital structure, the cost of capital is minimum and market price per share
is maximum.
3. The most profitable capital structure is one that tends to minimize ………………….and
maximize earning per equity share.
7.2 Major Considerations in Capital Structure Planning

ln planning the capital structure, one should keep in mind that there is no one definite
model that can be suggested/used as an ideal for all business undertakings. This is because
of varying circumstances of business undertakings. It is, therefore important to understand
that different types of capital structure would be required for different types of business
undertakings.

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