Page 180 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

Objectives Notes

After studying this unit, you will be able to:
 Explain the concept of capital structure;

 Differentiate between capital structure and financial structure;
 Learn about the various theories of capital structure;
 Discuss the optimum capital structure;
 Describe the various forms of capital structure.

Introduction

Every organisation requires funds to run and maintain its business. The required funds may be
raised from short-term sources or long-term sources or a combination both the sources of funds,
so as to equip itself with an appropriate combination of fixed assets and current assets. Current
assets to a considerable extent, are financed with the help of short-term sources. Normally, firms
are expected to follow a prudent financial policy, as revealed in the maintenance of net current
assets. This net positive current asset must be financed by long-term sources. Hence, long-term
sources of funds are required to finance for both (a) long-term assets (fixed assets) and
(b) networking capital (positive current assets).

The long-term financial strength as well as profitability of a firm is influenced by its financial
structure. The term ‘Financial Structure’ refers to the left hand side of the balance sheet as
represented by “total liabilities” consisting of current liabilities, long-term debt, preference
share and equity share capital. The financial structure, therefore, includes both short-term and
long-term sources of funds.

A firm can easily estimate the required funds by a detailed study of the investment decision. In
other words, anticipation of the required funds may be estimated by analyzing the investment
decision. Once anticipation of required funds is completed then the next step is financial for the
manager to make decisions related to the finance or the selected investment decisions. Generally
capital is raised from two prime sources (a) equity and (b) debt. Than the question is what should
be the proportion of equity and debt in the capital structure of a company.

8.1 Meaning of Capital Structure

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 consists 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.
Capital structure indicated by the following equation:
Capital Structure = Long-term Debt + Preferred Stock + Net worth
or
Capital Structure = Total Assets – Current Liabilities

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