Question
What is capital structure? Discuss the features of an appropriate capital structure.
Answer :
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Skip in 10
Finance is an important input for any type of business and is needed for working capital and for permanent investment. The total funds employed in a business are obtained from various sources. Some of the funds are permanently held in the business, such as share capital and reserves (owned funds), some others are held for a long period such as long-term borrowings or debentures, and still some other funds are in the nature of short-term borrowings.
Capital Structure represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, earned revenue, capital surpluses, etc.
The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees, customers, creditors, society in general. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced.
An appropriate capital structure should incorporate the following features:
1. Flexibility: A sound capita1 structure, must be flexible. The consideration of flexibility gives the financial manager ability to alter the firm's capital structure with a minimum cost and delay warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.
2. Profitability: A sound capital structure is also one that also possesses the feature of profitability, i.e., it must be advantageous to the company. It should permit the maximum use of leverage at a minimum cost with the constraints. Thus a sound capital structure tends to minimize 'cost' of financing and maximize earnings per share (EPS).
Solvency: A sound capital structure should also have the feature of solvency, i.e., it should use the debt capital only up to the point where significant risk it not added. As has been already observed the use of excessive debt threatens the solvency of the company.
Conservation: The
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