Page 86 - DMGT409Basic Financial Management

Unit 5: Capital Structure Decisions

5.1 Meaning of Capital Structure Notes

Capital structure is that part of financial structure, which represents long-term sources. The

term capital structure is generally defined to include only long-term debt and total stockholder
investment. The term capital structure refers to the mix of long-term sources of funds, such as
equity shares capital, reserves and surpluses, debenture, long-term debt from outside sources
and preference share capital. To quote Bogen, “Capital structure may consist of a single class of
stock, or it may be complicated by several issues of bonds and preferred stock, the characteristics
of which may vary considerably”. In other words, capital structure refers to the composition of
capitalisation, i.e., to the proportion between debt and equity that make up capitalisation.

Note Capital Structure = Long-term Debt + Preferred Stock + Net worth
or
Capital Structure = Total Assets – Current Liabilities

Thus, the capital structure of a firm consists of the shareholder‘ funds and debt. The inherent

financial stability of an enterprise and risk of insolvency to which it is exposed, are primarily
dependent on the source of its funds as well as the type of assets it holds and relative magnitude
of such asset categories.

5.2 Forms of Capital Structure

While making or farming the capital structure, a firm may use equity share capital or preference

share capital or debt capital (debentures or loans) or a combination of them all. However, the
use of any one of the above sources does not help to come up with an optimum capital structure.
Optimum capital structure is possible only when there is a mix of all the above sources (debt and
equity). The following are the forms of capital structure.
1. Complete equity share capital;
2. Different proportions of equity and preference share capital;
3. Different proportions of equity and debenture (debt) capital and

4. Different proportions of equity, preference and debenture (debt) capital.

5.3 Factors Determining the Capital Structure

The given below are the key factors which affect the capital structure decision:
1. Retaining Control: The capital structure of a company is also affected by the extent to
which the existing management of the company desires to maintain control over the affairs
of the company. If the company issues debt capital or preference capital, there is no risk of
dilutions of control. The company can also buy back the shares to increase the control of the
promoters over the company.

2. Nature of the Enterprise: Business firms with stable earnings or monopoly fi rms supplying
basic necessaries can have more or debt capital because they have the capacity to service

the debt. The firms without the above advantages should rely more on equity.

3. Purposes of Financing: If the purpose is productive, the firm may use the debt capital
otherwise it is better to rely more on equity capital.

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