Capital Structure Meaning, Features and Components

Table of Contents:-

1. Meaning of Capital Structure
2. What is Optimal Capital Structure?
3. Understanding Optimal Capital Structure
4. Features of an Optimal Capital Structure
5. Components of Capital Structure

Meaning of Capital Structure

Capital Structure is also known as the Capital Framework of a company. It comprises long-term capital funds raised by it from different sources for the conduct of its business. Various components of the Capital Structure are raised from time to time to meet the business needs of the company and generally consist of:

1. Equity shares
2. Preference shares
3. Debt funds (bonds and debentures)
4. Funds borrowed on a long-term basis, and
5. Retained earnings

Thus, we can say it is the decision making about the proportion of different sources of long-term funds required for running the firm.

According to James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt preferred stock, and common stock equity”.

According to Prasanna Chandra, “The composition of a firm’s financing consists of equity, preference and debt”.

According to Gerstenberg, “Capital structure of a company refers to the composition or make-up of its capitalization and it includes all long-term capital resources viz: loans, reserves, shares and bonds”.

The capital framework may have a two-fold impact on a company:

1) Cost of Capital: Companies having high-risk perceptions and higher leverage may probably have to pay a higher cost of capital.

2) Valuation: The valuation of a company is influenced by its capital framework. Companies with a high-risk perception and high leverage are likely to have a lower valuation. Whereas, the companies that are perceived as low-risk and have minimal leverage are more likely to have a higher valuation.

For example, if the firm’s ultimate objective is to maximise shareholder’s wealth, then the decision with respect to the capital structure would be significant as it can help in optimising the financial mix, which maximises the shareholder’s wealth by maximising the market price per share of the firm.

What is Optimal Capital Structure?

The capital structure of a company may be considered the optimal or balanced capital structure. Its financial plan has an appropriate debt-equity mix, which results in enhancing the company’s value at the maximum level. Achieving the minimum weighted average cost of a company is only possible under specific circumstances. If the optimal status of the capital structure of a company is achieved through external borrowings, the borrowed funds need to be given credit, which has facilitated to improvement of the market value of the company’s shores. However, if the borrowed funds result in a decline in the market value of the company’s shares, it may be concluded that the company’s capital structure has lost its way because of borrowed funds.

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Understanding Optimal Capital Structure

Maximisation of the market value of a company’s shares needs to be the objective of optimal capital planning. This maximisation is possible whenever the source of capital bears an equal marginal cost. The above concept is, however, more theoretical and simplistic. In practice, the establishment of an ‘Optimal Capital Structure’ is a challenging task and significant variations amongst inter-industry and intra-industry companies about ‘Capital Structure’ are noticed. The ‘Capital Structure’ decision of a company to have an optimal framework is impacted by numerous elements, specific to that company.

The individual or the team of individuals responsible for making decisions regarding the ‘Capital Framework’ of a company have a difficult task on their hands. Their perception of various determinant factors and their overall impact can influence their decisions.

These factors are mostly intangible, complex, psychological and subjective making it challenging to predict their impacts accurately. Two sets of individuals or teams from two similar companies may have different perceptions about such factors and come out with differing views and may decide in favour of different Optimal Capital Structures. Presumptions may go wrong as the ‘Capital Market’ are not perfect due to the lack of information and exposure to risk.

Features of an Optimal Capital Structure

An Optimal Capital Structure, which a company would prefer to have, may exhibit the following essential characteristics:

1) Profitability

The primary objective of any company is to generate profit. Its Capital Structure needs to conform with the above objective by minimising the cost of capital and maximising Earnings per Share (EPS).

2) Solvency

The Capital Structure of a company should be designed in such a manner that it continues to remain solvent.

3) Flexibility

The Capital Structure of a company should have flexibility. If required, the management should be capable of smoothly implementing changes to its various components, whether due to market forces or any other reasons.

4) Conservatism

The capital structure of a company needs to be conservative as far as the level of its debt components is concerned. Debt funds about the total funds should be within a manageable limit of the company depending upon its risk-bearing capacity.

5) Control

‘Capital Structure’ should be framed in such a way that there is the least possibility of taking over the control of a company by outside forces.

6) Simplicity

An optimal financial structure involves simple components like equity or preference shares, especially in the early stages of a company’s development. At later stages, the company may consider raising funds through the issue of debentures or bonds. Several components and issues of complex instruments like hybrid funds should be addressed in a restrictive manner.

7) Liquidity

A company’s liquidity position is the determinant of its capability to meet the liability arising out of debt capital. Such liability encompasses the payment of interest that accumulates over time on a debt instrument, as well as the repayment of the principal amount upon maturity. Thus, the ability to generate future revenue is the key factor in the liquidity status of a company.

Components of Capital Structure

Components of capital funds of a company may be classified based on their sources. Accordingly, they are put into two categories:

1) Owners’ Capital

Owners Capital consists of one or more of the following items:

i) Equity Shares

These are the primary sources of raising funds for an entrepreneur to start a business venture. Amongst all the components of the financial structure of a company, equity capital is the most costly source of funds. As the holders of equity capital are true owners of a company, they have the highest level of business risk. The balance of net profit, after payment to all other claimants, is distributed amongst all the shareholders of a company as dividends.

ii) Preference Shares

These shares are given preference over the ordinary shares in the following respects:

1. The dividend should be paid every year by the company without any delay to the preference shareholder, before the dividend payout to ordinary shareholders.
2. The dividend should be paid at a fixed rate to the preferred shareholders.
3. The return of capital should be repaid at the time of winding up of the company.

iii) Retained Earnings

A part of the net profit earned during a year, set aside for investment purposes or reinvestment in the business, is termed as ‘retained earnings. This is viewed as the most convenient source of internal finance and is utilised by the company for growth, expansion and diversification of the business.

2) Borrowed Capital

The capital borrowed may be of the following two items:

i) Debentures

When funds are raised through this mode, a company enters into a contract with the subscribers of the instrument (debenture) regarding the acknowledgement of the debt and payment of interest and principal. Debentures have a fixed interest rate of payment and are repayable on a fixed maturity date.

ii) Term Loans

‘Term Loans’ are institutional borrowings opted by companies as a source of long-term funds. The lenders are commercial banks and other financial institutions and they charge a fixed rate of interest for three years or more. Term loans are loans secured against a mortgage of property or any other security acceptable to the lending institutions.

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