It seems clear that more debt leads to more risk, which is bad, but more debt al

Question

It seems clear that more debt leads to more risk, which is bad, but more debt also leads to higher expected returns, which is good. However, finding the optimal capital balance seems quite nebulous. Moreover, the textbook indicates that capital structures vary widely across firms, even among firms within the same industry. This makes me wonder: If there really is an optimal capital structure, wouldn 't firms migrate toward it, with the result that firms ' capital structures would be more similar than they are within any given industry?

Explanation / Answer

Concept of Capital Structure:

The relative proportion of various sources of funds used in a business is termed as financial structure. Capital structure is a part of the financial structure and refers to the proportion of the various long-term sources of financing. It is concerned with making the array of the sources of the funds in a proper man­ner, which is in relative magnitude and proportion.

The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

Again, each component of capital structure has a different cost to the firm. In case of companies, it is financed from various sources. In proprietary concerns, usually, the capital employed, is wholly contributed by its owners. In this context, capital refers to the total of funds supplied by both—owners and long-term creditors.

The question arises: What should be the appropri­ate proportion between owned and debt capital? It depends on the financial policy of iindividual firms. In one company debt capital may be nil while in another such capital may even be greater than the owned capital. The proportion between the two, usually expressed in terms of a ratio, denotes the capital structure of a company.

Importance of Capital Structure:

Decisions relating to financing the assets of a firm are very crucial in every business and the finance manager is often caught in the dilemma of what the optimum proportion of debt and equity should be. As a general rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Capital structure is usually designed to serve the interest of the equity shareholders.

Therefore instead of collecting the entire fund from shareholders a portion of long term fund may be raised as loan in the form of debenture or bond by paying a fixed annual charge. Though these payments are considered as expenses to an entity, such method of financing is adopted to serve the interest of the ordinary share­holders in a better way.

The importance of designing a proper capital structure is explained below:

Value Maximization:

Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.

Cost Minimization:

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.

Increase in Share Price:

Capital structure maximizes the company’s market price of share by increas­ing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.

Investment Opportunity:

Capital structure increases the ability of the company to find new wealth- creating investment opportunities. With proper capital gearing it also increases the confidence of sup­pliers of debt.

Growth of the Country:

Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.

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