What is Capital Structure
The most crucial component of starting a business is capital. It acts as the foundation of the company. Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined as the combination of equity and debt that is put into use by a company in order to finance the overall operations of the company and for its growth.
Types of Capital Structure
The meaning of Capital structure can be described as the arrangement of capital by using different sources of long term funds which consists of two broad types, equity and debt. The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans etc. These funds are raised for running the business.
Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different types
a) Retained earnings: Retained earnings are part of the profit that has been kept separately by the organisation and which will help in strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money which the company owners have invested at the time of opening the company or received from shareholders as a price for ownership of the company.
Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business. There are different forms of debt capital.
- Long Term Bonds: These types of bonds are considered the safest of the debts as they have an extended repayment period, and only interest needs to be repaid while the principal needs to be paid at maturity.
- Short Term Commercial Paper: This is a type of short term debt instrument that is used by companies to raise capital for a short period of time
Optimal Capital Structure
Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in maximising the value of a company in the market while at the same time minimises its cost of capital.
Capital structure varies across industries. For a company involved in mining or petroleum and oil extraction, a high debt ratio is not suitable, but some industries like insurance or banking have a high amount of debt as part of their capital structure.
Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total capital of the firm. It is also known as capital gearing. A firm having a high level of debt is called a highly levered firm while a firm having a lower ratio of debt is known as a low levered firm.
Importance of Capital Structure
Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the other factors that highlight the importance of capital structure
- A firm having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possesses. It will lead to a higher valuation in the market.
- A good capital structure ensures that the available funds are used effectively. It prevents over or under capitalisation.
- It helps the company in increasing its profits in the form of higher returns to stakeholders.
- A proper capital structure helps in maximising shareholder’s capital while minimising the overall cost of the capital.
- A good capital structure provides firms with the flexibility of increasing or decreasing the debt capital as per the situation.
Factors Determining Capital Structure
Following are the factors that play an important role in determining the capital structure:
- Costs of capital: It is the cost that is incurred in raising capital from different fund sources. A firm or a business should generate sufficient revenue so that the cost of capital can be met and growth can be financed.
- Degree of Control: The equity shareholders have more rights in a company than the preference shareholders or the debenture shareholders. The capital structure of a firm will be determined by the type of shareholders and the limit of their voting rights.
- Trading on Equity: For a firm which uses more equity as a source of finance to borrow new funds to increase returns. Trading on equity is said to occur when the rate of return on total capital is more than the rate of interest paid on debentures or rate of interest on the new debt borrowed.
- Government Policies: The capital structure is also impacted by the rules and policies set by the government. Changes in monetary and fiscal policies result in bringing about changes in capital structure decisions.
The concept of the Capital structure, along with the components and the factors that influence capital structure is discussed. To learn more about such important concepts, stay tuned to BYJU’S.
Also See:
- Difference Between Capital Structure and Financial Structure
Differences Between Debt and Equity Capital
Differences Between Equity Share Capital and Preference Share Capital
Mcqs on Capital Budgeting
FAQs
It acts as the foundation of the company. Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined as the combination of equity and debt that is put into use by a company in order to finance the overall operations of the company and for its growth.
What are the 4 types of capital structure? ›
One may use it to finance overall business operations and investment activities. The types of capital structure are equity share capital, debt, preference share capital, and vendor finance.
What is the meaning and importance of capital structure? ›
It represents the way that a company finance its assets and is essential in determining its financial health and risk profile. For instance, a company may have a capital structure of 60% equity and 40% debt, indicating that 60% of its funds are raised through equity, and 40% through debt.
What are the 5 factors determining capital structure? ›
of a firm. Tangibility of assets, growth opportunities, size, uniqueness, business risk, and profitability are some of the major factors which determine the capital structure.
What are the important factors in making capital structure decisions? ›
In summary, various factors impact capital structure decisions, including debt ratings, business characteristics, external factors, agency costs, and costs of asymmetric information. Understanding these factors can help managers make informed decisions that maximize shareholder wealth and company growth.
What are the 4 theories of capital structure? ›
Answer: The optimal capital structure provides the maximum profit with maximum control over the investment and has a minimum risk factor. Answer: There are four important capital structure theories: net income theory, net operating income theory, traditional theory, and Modigliani-Miller theory.
What are the 4 types of capital and examples? ›
The capital of a business is the money it has available to pay for its day-to-day operations and to fund its future growth. The four major types of capital include working capital, debt, equity, and trading capital; trading capital is used by brokerages and other financial institutions.
What is the meaning of capital structure and factors affecting it? ›
The meaning of Capital structure can be described as the arrangement of capital by using different sources of long term funds which consists of two broad types, equity and debt. The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans etc.
How to determine capital structure? ›
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular.
What is the basic goal of capital structure? ›
The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital). In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value.
An optimal capital structure is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. Minimizing the weighted average cost of capital (WACC) is one way to optimize for the lowest cost mix of financing.
How to calculate cost of capital? ›
WACC calculates the average price of all of a company's capital sources, weighted by the proportion of each type of funding used. WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity) + (Weight of Preferred Stock * Cost of Preferred Stock).
Which is the principle of capital structure? ›
The principles of structure include maintaining an optimal balance between equity and debt. It includes considering the cost of capital, aligning with the company's risk tolerance, and adjusting to economic conditions.
What is capital structure and its importance? ›
Capital structure relates to how much money—or capital—is supporting a business, financing its assets, and funding its operations. It can also show company acquisitions and capital expenditures that can influence the business's bottom line.
What is the target capital structure? ›
The target capital structure of a company refers to the capital which the company is striving to obtain. In other words, target capital structure describes the mix of debt, preferred stock and common equity which is expected to optimize the stock price of a company.
What is a good debt to equity ratio? ›
Generally speaking, a debt-to-equity ratio of 1.5 or less is considered good. A high debt-to-equity ratio indicates that a company funds its operations and growth primarily with debt, indicating a higher risk profile because they have more debt to repay.
What are the different types of structural capital? ›
Some common elements of structural capital include data, intellectual property, values, principles and media. It can also include the procedures and methods that the company uses in its operations and along with its organizational culture and leadership structure.
What are the four principal forms of capital? ›
In globalization, there are four forms of investments for wealth: human capital, financial capital, resource capital, and political capital. Discover examples of each of these types to understand their role in the global economy.
What are the 5 types of economic capital? ›
It is useful to differentiate between five kinds of capital: financial, natural, produced, human, and social. All are stocks that have the capacity to produce flows of economically desirable outputs. The maintenance of all five kinds of capital is essential for the sustainability of economic development.
