Page 181 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 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.

8.2 Optimum Capital Structure

In taking a financing decision, the financial manager’s job is to come out with an optimum
capital structure. Optimum capital structure is that capital structure at that level of debt - equity
proportion, where the market value per share is maximum and the cost of capital is minimum.
The same to quote, Ezra, “optimum leverage is that mix of debt and equity which will maximise
the market value of the company and minimise the company’s overall cost of capital.” The study
of capital structure involves a discussion of the nature of the industry and specific circumstances
of the business enterprise in question, besides the general theory of finance. It is difficult to
define an ideal capital structure. A company’s capital structure is a function of the nature of its
business an how risky the particular business is, and therefore, a matter of business judgment.
As observed by Van Horne, “In the optimum capital structure, the marginal real cost of each
available method of financing is the same”. As Guthmann and Dougall rightly remark, from a
strictly financial point of view, the optimum capital structure is achieved by balancing the
financing, so as to achieve the lowest average cost of long-term funds. This in turn produces that
maximum market value for the total securities issued against a given amount of corporate
income. The optimum capital structure keeps balance between share capital and debt capital.
The primary reason for the employment of debt by an enterprise can be stated as upto a certain
point, debt is from the point of view of the ownership, a less expensive source of funds than
equity capital. Hence, optimum capital structure keeps a balance between debt capital and
equity capital.

8.3 Features of an Appropriate Capital Structure

Construction of optimum capital structure is very important for a firm, since its value depending
on the capital structure. Hence, the financial manager or the concerned person should develop
an appropriate capital structure, which is helpful to maximise shareholder wealth. This can be
done only when all those factors., which are relevant to the company’s capital structure decision,
are properly analysed and balanced. Capital structure should be planned, keeping in view the
interest of ordinary shareholder because they are the ultimate owners of a business enterprise
and have the right to select the directors. However, the interest of the other groups, such as,
employees, customers, creditors, society and government should also receive reasonable
consideration. There is no tailor-made capital structure for all business enterprises. There are
certain common characteristics that categorise industries. The study of capital structure involves
a study of the debt-equity mix with the object of lowering the overall cost of capital and with a
view to maximizing the market value of the firm’s securities.
An appropriate capital structure should have the following features:
1. Profitability/Return: As we have seen in the above discussion the appropriate capital
structure is one, which is most advantageous. With the constraints, maximum use of
leverage at a minimum cost should be made. In other words, it should generate maximum
returns to the owners without adding additional cost.
2. Solvency/Risk: The use of more or excessive debt threatens the solvency of the firm. Debt
should be used till the point where, debt does not add significant risk, otherwise use of
debt should be avoided.

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