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
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
The primary meaning ofcost of capitalis simply the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.
In other words, Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same Money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.
The cost of various capital sources varies from company to company, and depends on factors such as its operating history, profitability,credit worthiness, etc. In general, newer enterprises with limited operating histories will have higher costs of capital than established companies with a solid track record, since lenders and investors will demand a higher risk premium for the former.
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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.
Debt financing is when a company borrows money from lenders, such as banks or bondholders. Equity financing is when a company sells shares of ownership to investors. Hybrid financing is a combination of debt and equity financing.
The cost of capital is the rate of return that a company must earn on its investments in order to satisfy its investors. The weighted Average cost of capital (WACC) is a measure of the overall cost of capital for a company. The WACC is calculated by taking the weighted average of the cost of debt and the cost of equity.
The cost of debt is the interest rate that a company pays on its loans. The cost of equity is the rate of return that investors expect to earn on their investment in a company. The cost of equity is typically higher than the cost of debt because equity investors are exposed to more risk.
The capital asset pricing model (CAPM) is a model that is used to estimate the cost of equity. The CAPM takes into account the risk-free rate of return, the market risk premium, and the beta coefficient of the company.
The dividend DISCOUNT model (DDM) is a model that is used to estimate the value of a company’s equity. The DDM takes into account the company’s expected future dividends, the discount rate, and the Growth rate of dividends.
The risk-free rate of return is the rate of return that an investor can earn on a risk-free investment, such as a U.S. Treasury bond. The market risk premium is the additional return that an investor expects to earn on a risky investment, such as a stock, over the risk-free rate of return.
The beta coefficient is a measure of the systematic risk of a company. Systematic risk is the risk that cannot be diversified away. The higher the beta coefficient, the more risky the company is.
Capital structure theory is the study of how a company’s capital structure affects its cost of capital and value. The Modigliani-Miller theorem is a theory that states that the value of a company is not affected by its capital structure. The pecking order theory is a theory that states that companies prefer to finance their investments with internal funds, followed by debt, and then equity. The trade-off theory is a theory that states that there is an optimal capital structure that minimizes the company’s cost of capital.
Agency cost theory is a theory that states that there are costs associated with the separation of ownership and control in a company. These costs can arise from conflicts of interest between managers and shareholders. Signaling theory is a theory that states that companies use their capital structure to signal their investment opportunities to investors. Debt overhang theory is a theory that states that too much debt can make it difficult for a company to invest in new projects. Liquidity preference theory is a theory that states that companies prefer to finance their investments with debt because debt is a more liquid form of financing. Tax shield theory is a theory that states that the interest expense on debt is tax deductible, which lowers the company’s tax liability. Homemade leverage theory is a theory that states that investors can create their own leverage by borrowing money to buy shares of a company.
Optimal capital structure is the mix of debt and equity financing that minimizes the company’s cost of capital and maximizes its value. Capital structure adjustment is the process of changing a company’s capital structure. Capital structure management is the process of managing a company’s capital structure. Capital structure planning is the process of developing a plan for a company’s capital structure. Capital structure analysis is the process of analyzing a company’s capital structure. Capital structure DECISION MAKING is the process of making decisions about a company’s capital structure. Capital structure evaluation is the process of evaluating a company’s capital structure. Capital structure forecasting is the process of forecasting a company’s capital structure. Capital structure risk management is the process of managing the risks associated with a company’s capital structure. Capital structure restructuring is the process of changing a company’s capital structure in response to financial distress. Capital structure bankruptcy is the process of liquidating a company’s assets in order to repay its debts.
What is a business model?
A business model is a conceptual tool that contains a set of Elements and their relationships and allows expressing the business logic of a specific firm. It is a description of the value a company offers to one or several segments of customers and of 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:
The product-based business model: This is the most common type of business model, in which a company sells products to customers.
The service-based business model: In this type of business model, a company sells Services to customers.
The subscription-based business model: In this type of business model, a company charges customers a recurring fee for access to its products or services.
The freemium business model: In this type of business model, a company offers a basic version of its product or service for free, and then charges customers for additional features or functionality.
The advertising-based business model: In this type of business model, a company generates revenue by selling advertising space on its website or app.
The affiliate marketing business model: In this type of business model, a company partners with other businesses to promote their products or services. The company then earns a commission on any sales that are generated through its affiliate links.
What are the benefits of having a strong business model?
A strong business model can help a company to:
Attract and retain customers
Generate revenue
Grow its business
Stay competitive
Avoid risks
What are the challenges of creating a strong business model?
Creating a strong business model can be challenging, as it requires a deep understanding of the market, the competition, and the company’s own strengths and weaknesses. However, the benefits of having a strong business model can make it well worth the effort.
What are some common mistakes to avoid when creating a business model?
Some common mistakes to avoid when creating a business model include:
Not understanding the market
Not understanding the competition
Not understanding the company’s own strengths and weaknesses
Not having a clear value proposition
Not having a clear target market
Not having a clear revenue model
Not having a clear marketing plan
Not having a clear operational plan
Not having a clear financial plan
How can I create a strong business model?
There is no one-size-fits-all answer to this question, as the best way to create a strong business model will vary depending on the specific company and its circumstances. However, some general tips for creating a strong business model include:
Conduct extensive market research
Understand the competition
Understand the company’s own strengths and weaknesses
Develop a clear value proposition
Develop a clear target market
Develop a clear revenue model
Develop a clear marketing plan
Develop a clear operational plan
Develop a clear financial plan
What are some Resources that can help me create a strong business model?
There are many resources available to help companies create strong business models. Some of these resources include:
Books on business models
Articles on business models
Online courses on business models
Business model templates
Business model canvases
Business model mentors
Business model consultants
Question 1
A company’s capital structure is the mix of debt and equity financing that it uses to fund its operations. The cost of capital is the rate of return that a company must earn on its investments in order to satisfy its investors.
Which of the following statements is true about capital structure and cost of capital?
(A) A company’s capital structure has no effect on its cost of capital.
(B) A company’s cost of capital is always equal to its weighted average cost of debt and equity.
(C) A company’s capital structure can affect its cost of capital by changing the riskiness of its investments.
(D) A company’s cost of capital is always equal to the risk-free rate of return.
Answer
The correct answer is (C). A company’s capital structure can affect its cost of capital by changing the riskiness of its investments. When a company uses more debt financing, its riskiness increases because it has more debt to repay. This means that investors will demand a higher return on their investment, which will increase the company’s cost of capital.
Question 2
A company’s weighted average cost of capital (WACC) is a measure of the average cost of capital that a company incurs from its various sources of financing. The WACC is calculated by taking a weighted average of the costs of debt, equity, and preferred stock.
Which of the following statements is true about the WACC?
(A) The WACC is always equal to the company’s cost of debt.
(B) The WACC is always equal to the company’s cost of equity.
(C) The WACC is always equal to the company’s cost of preferred stock.
(D) The WACC is a weighted average of the company’s cost of debt, equity, and preferred stock.
Answer
The correct answer is (D). The WACC is a weighted average of the company’s cost of debt, equity, and preferred stock. The weights are determined by the relative proportions of each type of financing that the company uses.
Question 3
A company’s cost of debt is the rate of return that it must pay on its outstanding debt. The cost of debt is typically higher than the cost of equity because debt is a riskier investment for lenders.
Which of the following factors would most likely increase a company’s cost of debt?
(A) A decrease in the company’s credit rating.
(B) An increase in the company’s debt-to-equity ratio.
(C) A decrease in the company’s interest coverage ratio.
(D) An increase in the company’s tax rate.
Answer
The correct answer is (A). A decrease in the company’s credit rating would make it more difficult for the company to borrow money, and lenders would demand a higher interest rate to compensate for the increased risk.
Question 4
A company’s cost of equity is the rate of return that it must earn on its equity investments in order to satisfy its shareholders. The cost of equity is typically higher than the cost of debt because equity is a riskier investment for shareholders.
Which of the following factors would most likely increase a company’s cost of equity?
(A) A decrease in the company’s stock price.
(B) An increase in the company’s beta coefficient.
(C) A decrease in the company’s dividend yield.
(D) An increase in the company’s tax rate.
Answer
The correct answer is (B). A company’s beta coefficient is a measure of its systematic risk. A higher beta coefficient indicates that the company’s stock price is more volatile than the stock market as a whole. This means that shareholders are more likely to lose money on their investment, and they will demand a higher return to compensate for the increased risk.
Question 5
A company’s cost of capital is an important factor in its financial decision-making. The cost of capital is used to calculate the company’s hurdle rate, which is the minimum rate of return that the company must earn on its investments in order to be profitable.
Which of the following statements is true about the cost of capital?
(A) The cost of capital is always equal to the company’s weighted average cost of debt and equity.
(B) The cost of capital is always equal to the company’s cost of debt.
(C) The cost of capital is always equal to the company’s cost of equity.
(D) The cost of capital is a measure of the average cost of capital that a company incurs from its various sources of financing.