Capital Structure

FINANCIAL MANAGEMENT CAPITAL STRUCTURE Its meaning, patterns of capital structure, theories of capital structure, factors determining capital structure, difference between capital structure and financial structure SUBMITTED BY 

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eaning of Capital Structure Capital Structure is referred to as the ratio of different -inds of securities raised b. a firm as long/term finance0 The capital structure in1ol1es two decisions/ 

T.pe of securities to be issued are e2uit. shares, preference shares and long term borrowings *#ebentures0

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R elati1e ratio of securities can be determined b. process of capital gearing0 3n this basis, the companies are di1ided into two/ %0 !ighl. geared companies / Those companies whose proportion of e2uit. capitali4ation is small0 2.

Low geared companies / Those companies whose e2uit. capital dominates total capitali4ation0

5or instance / There are two companies A and )0 Total capitali4ation amounts to be I"R &'',''' in each case0 The ratio of e2uit. capital to total capitali4ation in compan. A is I"R 6',''', while in compan. ), ratio of e2uit. capital is I"R  %6',''' to total capitali4ation, i0e0, in Compan. A, proportion is &67 and in compan. ), proportion is 8670 In such cases, compan. A is considered to be a highl. geared compan. and compan. ) is low geared compan.0 OR

Capital structure describes how a corporation finances its assets0 This structure is usuall. a combination of se1eral sources of senior debt, me44anine debt and e2uit.0 9ise companies use the right combination of senior debt, me44anine debt and e2uit. to -eep their true cost of capital as low as possible0 #epending on how comple: the structure, there ma. in fact be do4ens of financing sources included, drawing on funds from a 1ariet. of entities in order to generate the complete financing pac-age0 Capital structure is what describes the relationship of these financing sources as the. appear on the corporation;s balance sheet0

E:amples of capital sources that ma. be included in a corporation;s capital structure are< 

9or-ing Capital

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E2uit.

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Senior #ebt

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e44anine #ebt

PATTER"S 35 CAPITAL STRUCTURE The composition of capital structure can be recalled as follows< %0

3n the basis of sources of funds,        

&0

3n the basis of ownership capital,   

>0

  

#ebenture capital Long/term debts Cash credit Current liabilit.

3n the basis of cost of capital,  

60

E2uit. share capital Preference share capital Reser1e and surplus

3n the basis of borrowed capital, 

?0

Preference share capital E2uit. share capital #ebenture capital Long/term debt Reser1e and surplus Current liabilit. Share premium P=L account

5i: cost of capital +ariable cost of capital

3n the basis of nature and t.pe of capital, 

Simple capital structure *when the capital structure is composed of a single source for e0g0 E2uit. capital including retained earnings 

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Comple: capital structure *when the capital structure is composed of more than one source not of identical nature for e0g0 debenture,  preference share, current liabilities

CAPITAL STRUCTURE T!E3RIES 1st Theory of Capital Structure

 "ame of Theor. @ "et Income Theor. of Capital Structure This theor. gi1es the idea for increasing mar-et 1alue of firm and decreasing o1erall cost of capital0 A firm can choose a degree of capital structure in which debt is more than e2uit. share capital0 It will be helpful to increase the mar-et 1alue of firm and decrease the 1alue of o1erall cost of capital0 #ebt is cheap source of finance because its interest is deductible from net profit before ta:es0 After deduction of interest compan. has to pa. less ta: and thus, it will decrease the weighted a1erage cost of capital0 5or e:ample if .ou ha1e e2uit. debt mi: is 6'