Capital Structure

CAPITAL STRUCTURE

The financial requirement of a firm can be met through ownership capital and/or borrowed capital. The ownership capital refers to the amount of capital contributed by the owners. In case of a company, it refers to the amount of funds raised by issuing Shares. The main characteristic of the ownership capital is that its contributors are entitled to get dividend out of earnings after the payment of interest and taxes. Hence, the rate of return on such capital depends upon the level of profits earned, and, if there are no profits, no dividend may be paid.

Borrowed capital, on the other hand, refers to the amount of funds raised through long term loans and Debentures on which its contributors are entitled to a fixed rate of interest which has to be paid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also a commitment that the principal amount shall be repaid on maturity. However, it is still considered advantageous to finance business activities through borrowed capital because if the rate of earnings from the planned business Investment is expected to be better than the rate of interest on the borrowed funds, it shall ensure higher returns on owners’ funds. Let us take an example and understand this concept more clearly.

“The mix of Equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure.”

Thus, the term capital structure refers to the makeup of a firm’s capital in terms of the planned mix of different kinds of long-term funds like equity shares, preference shares, debentures and long term funds. So capital structure involves two basic decisions:

(a) The type of securities to be issued or raised; and

(b) The relative proportion of each type of security

Factors Determining the Capital Structure

Expected earnings and their stability: If the expected earnings, in terms of rate of return on the amount to be invested are sufficiently large, use of debt is considered quite desirable. Not only that, the stability of earnings should also be taken into account because if the firm is engaged is business activities in which sales and profits are subject to wide fluctuations, it will be risky to use higher proportion of debt. In other words, if there is an element of uncertainty about the expected earnings it is considered better to rely more on equity share capital. However, with assured prospects of rising earnings, there should be greater reliance on debt so as to take advantage of leverage effect.

Cost of debt : If the rate of interest on borrowings is lower than the expected rate of return on capital employed, then debt may be preferred. With lower cost of debt financing, the overall cost of financing is reduced and the return on equity capital will be higher, as explained earlier.

Right to manage the business: You know that the debenture holders and preference shareholders do not have much say in management of the company. This authority lies primarily with the equity shareholders who have the voting rights. Hence, while deciding on the mix of equity and debt, the promoters/existing management of the company may also take into account the possible effect of raising funds through equity shares on the right to control the business. In order to retain their right to control the affairs of the company, they may prefer to raise additional funds mainly through debentures and preference shares.

Capital Market conditions: The conditions in the capital market also influence the capital structure decision. At times capital market is so depressed that the investors are unwilling to subscribe to shares. In such a situation, it is considered better to rely on debt or defer the decision till a favourable market condition is restored.

Regulatory norms : While deciding on the capital structure, the legal constraints like the limit on debt-equity ratio should also be kept in view. At present, such limit is 2:1 in most cases. This implies that at any point of time, the debt should not be more than twice the amount of share capital. This limit keeps on changing with changing economic Environment and varies from Industry to industry.

Flexibility: The planned capital structure should be flexible enough to raise additional funds without much difficulty. The company should be able to raise additional capital in the form of debt or equity whenever required. But if the company’s capital structure has too much debt, then the lenders may not be able to give more loan to the company. In a such a situation it may be forced to raise the funds only through shares for which the capital market condition may not be conducive. Similarly, when on account of declining business and lack of other investment opportunities the funds need to be refunded, it may not be possible to do so if the company has heavily relied on equity shares which cannot be redeemed easily. Hence, to ensure an element of flexibility, it is better if the firm relies more on redeemable securities that can be paid off if necessary and, at the same time, have some unused debt raising capacity so that future financial needs can be fully taken care of without much difficulty.

Investors’ Attitude towards investment: While planning the capital structure of a company one must bear in mind that all investors do not have the same attitude towards their investment. Some are highly conservative who prefer safety to return. For such investors, debentures are considered most suitable. As against this, there are some who are interested in high return on their investments and are ready to take the risk involved. Such investors prefer equity shares. Then, there are many who are willing to take a limited risk provided the return is better than the rate on secured debentures and Bonds. Preference shares are most suitable for this category of investors. In order to attract all categories of investors, it is considered more desirable to issue different types of securities especially when the amount of capital requirement is large.

Capital structure is the mix of debt and equity financing that a company uses to fund its operations. The optimal capital structure is the mix that minimizes the company’s Cost of Capital and maximizes its value.

There are a number of factors that companies consider when determining their capital structure, including the risk of the company’s business, the tax treatment of debt and equity, and the cost of debt and equity financing.

Debt financing is a form of financing in which a company borrows Money from a lender. The lender agrees to lend the money to the company for a specified period of time, at a specified interest rate. The company is then obligated to repay the loan, plus interest, over the specified period of time.

Equity financing is a form of financing in which a company sells shares of ownership in the company to investors. The investors become shareholders in the company and are entitled to a share of the company’s profits.

Hybrid financing is a form of financing that combines Elements of debt and equity financing. For example, a company might issue convertible bonds, which are bonds that can be converted into shares of equity at a specified price.

Capital structure adjustment is the process of changing a company’s capital structure. This can be done by issuing new debt or equity, or by repaying existing debt.

Capital structure and risk: The risk of a company’s business is one of the most important factors that companies consider when determining their capital structure. Companies with more risky businesses tend to use more debt financing, because debt financing provides a tax shield.

Capital structure and return on equity: The return on equity (ROE) of a company is a measure of how profitable the company is. ROE is calculated by dividing the company’s net income by its equity. Companies with higher ROEs tend to use more debt financing, because debt financing increases ROE.

Capital structure and cost of capital: The cost of capital of a company is the weighted Average of the cost of debt and the cost of equity. The cost of capital is used to calculate the company’s DISCOUNT rate, which is used to value the company’s future cash flows. Companies with lower costs of capital tend to use more debt financing, because debt financing lowers the company’s cost of capital.

Capital structure and taxes: The tax treatment of debt and equity is another important factor that companies consider when determining their capital structure. Interest payments on debt are tax-deductible, while dividends on equity are not. This means that companies with more debt financing have a lower tax bill than companies with more equity financing.

Capital structure and bankruptcy: Bankruptcy is a legal proceeding in which a company is unable to repay its debts. Companies with more debt financing are more likely to go bankrupt than companies with less debt financing. This is because debt financing increases the risk of financial distress.

Capital structure and agency costs: Agency costs are costs that arise due to the separation of ownership and control in a company. These costs can include the costs of monitoring managers, the costs of bonding managers, and the costs of lost opportunities. Companies with more debt financing have higher agency costs than companies with less debt financing. This is because debt financing increases the risk of managerial opportunism.

Capital structure and signaling: Signaling is a theory that suggests that companies use their capital structure to send signals to investors about their future prospects. Companies with good future prospects are more likely to use more debt financing, because debt financing signals to investors that the company is confident in its future prospects.

Capital structure and market timing: Market timing is the theory that companies can time the market to issue debt or equity at the most advantageous time. Companies that are able to time the market correctly can reduce their cost of capital.

Capital structure and Corporate Governance: Corporate governance is the system of rules, practices, and processes that are used to direct and control a company. Capital structure is an important part of corporate governance, because it affects the way that a company is controlled.

Capital structure and international finance: Capital structure is also an important issue in international finance. Companies that operate in multiple countries need to consider the tax treatment of debt and equity in each country, as well as the exchange rate risk.

Capital structure and empirical evidence: There is a large body of empirical evidence on capital structure. This evidence suggests that there is no one-size-fits-all optimal capital structure for all companies. The optimal capital structure for a company depends on a number of factors, including the company’s risk, its tax situation, and its cost of capital.

Capital structure and future research: There are a number of areas where future research on capital structure is needed. One area is the role of agency costs in capital structure decisions. Another area is the role of market timing in capital structure decisions. Finally, more research is needed on the capital structure of companies in emerging markets.

What is a business model?

A business model is a framework for describing the value a company offers to one or several segments of customers and the architecture of the firm and its Network of partners for creating, Marketing, and delivering this value and relationship capital, to generate profitable and sustainable revenue streams.

What are the different types of business models?

There are many different types of business models, but some of the most common include:

Product-based business models: These businesses sell physical or digital products to customers.
Service-based business models: These businesses provide Services to customers, such as consulting, cleaning, or transportation.
Subscription-based business models: These businesses charge customers a recurring fee for access to their products or services.
Freemium business models: These businesses offer a basic version of their product or service for free, and then charge customers for premium features or add-ons.
Advertising-based business models: These businesses generate revenue by selling advertising space on their websites or apps.
E-Commerce business models: These businesses sell products or services online.
Marketplace business models: These businesses connect buyers and sellers of goods or services.
Platform business models: These businesses provide a platform for other businesses to connect with their customers.

What are the benefits of having a strong business model?

A strong business model can help a company to:

Generate more revenue: A well-designed business model can help a company to capture more of the value that it creates.
Attract and retain customers: A strong business model can help a company to attract and retain customers by providing them with a valuable product or service.
Build a strong competitive position: A strong business model can help a company to build a strong competitive position by making it difficult for competitors to replicate its success.
Create a sustainable business: A strong business model can help a company to create a sustainable business by generating enough revenue to cover its costs and make a profit.

What are the challenges of developing a strong business model?

Developing a strong business model can be challenging, as it requires a deep understanding of the company’s target market, its competitors, and the industry in which it operates. Additionally, the business model must be flexible enough to adapt to changes in the market and the company’s environment.

What are some common mistakes that companies make when developing their business models?

Some common mistakes that companies make when developing their business models include:

Not understanding their target market: Companies often make the mistake of not fully understanding their target market. This can lead to developing a product or service that is not what customers want or need.
Not understanding their competitors: Companies also often make the mistake of not fully understanding their competitors. This can lead to developing a product or service that is too similar to what competitors offer, or that does not offer a clear competitive advantage.
Not understanding the industry: Companies also often make the mistake of not fully understanding the industry in which they operate. This can lead to developing a business model that is not sustainable in the long run.
Not being flexible enough: Companies must be able to adapt their business models to changes in the market and their environment. If a company’s business model is not flexible enough, it may not be able to survive in the long run.

What are some tips for developing a strong business model?

Some tips for developing a strong business model include:

Start with a clear understanding of your target market: What are the needs and wants of your target market? What are your competitors offering?
Develop a product or service that meets the needs of your target market: Your product or service must be something that customers want or need.
Create a sustainable business model: Your business model must be able to generate enough revenue to cover your costs and make a profit.
Be flexible enough to adapt to changes: The market and your environment are constantly changing. Your business model must be flexible enough to adapt to these changes.

Which of the following is not a source of capital?
(A) Debt
(B) Equity
(C) Retained earnings
(D) Cash flow
Which of the following is a characteristic of debt financing?
(A) It is a fixed obligation.
(B) It is a source of permanent financing.
(C) It is a source of short-term financing.
(D) It is a source of equity financing.
Which of the following is a characteristic of equity financing?
(A) It is a fixed obligation.
(B) It is a source of permanent financing.
(C) It is a source of short-term financing.
(D) It is a source of debt financing.
Which of the following is a disadvantage of debt financing?
(A) It increases the risk of bankruptcy.
(B) It increases the cost of capital.
(C) It reduces the flexibility of the firm.
(D) All of the above.
Which of the following is a disadvantage of equity financing?
(A) It dilutes the ownership of the firm.
(B) It increases the cost of capital.
(C) It reduces the flexibility of the firm.
(D) All of the above.
Which of the following is a goal of capital structure management?
(A) To minimize the cost of capital.
(B) To maximize the value of the firm.
(C) To maintain a constant debt-equity ratio.
(D) To maximize the return on equity.
Which of the following is a method of capital structure management?
(A) The target capital structure approach.
(B) The pecking order approach.
(C) The trade-off approach.
(D) All of the above.
The target capital structure approach is based on the idea that the firm should maintain a constant debt-equity ratio.
(A) True
(B) False
The pecking order approach is based on the idea that firms prefer to finance their investments with internal funds, followed by debt, and then equity.
(A) True
(B) False
The trade-off approach is based on the idea that there is an optimal debt-equity ratio that minimizes the cost of capital.
(A) True
(B) False