Capital Structure

Topics: Finance, Corporate finance, Capital structure Pages: 12 (3498 words) Published: April 24, 2013

Capital structure (CS) is one of the most important aspects of the Financial Management of any organization. It aims is to identify and implement the best capital structure proportion possible that suits the organizations needs and objectives. An optimal Capital structure boosts the prosperity of the company in the long run and reduces the risk.

CS is a mixture of a company's current and non current debt, common and preferred equity. It's the way a company finances its functions generally and how it can grow by using different funds resource. The capital structure of a company may be simple, compound or complex. A simple capital structure is composed of one single security base (equity share). While a compound capital structure indicates a combination of two security base in form of equity and preference share capital. The complex capital structure is made up of many security bases, beside the above mentioned shares it includes series of debentures or bonds and loans from other sources. Importance of optimal Capital Structure

A proper capital structure is a serious matter for any business institute.  The choice is essential not only to make the most of income to various organizational populations, but also due to the influence of such a choice has on an institute’s capability to tackle its competitive environment. An ideal debt and equity mix reduces the overall cost of capital and increases the return on risk. It also helps the company to achieve its long term as well as short term objectives with efficiency and effectiveness. With a perfect capital mix organizations can take advantages of opportunities when available. The same point was emphasized by Michael Milken, in an article written for the "Wall street journal".

"…capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies."

Over and over history shows that, sometimes even a small mistake in defining the level of liability or equity can lead to disaster. Therefore managers are under more pressure to get the right mix on the balance sheet. Given below some examples of inappropriate use of CS which lead leading companies to financial crisis: Readers’ Digest Association a well known magazines publishing association filed for bankruptcy and obtained $525 M. It has $2.3 B in debt before announcing the collapsing.

TXU Corporation made headlines of Bloomberg Business Week. The corp. was highly leveraged as compared to equity. It has $36.77 B long-term debt as per regulatory filing.

General Growth Properties with an ownership in more than 200 regional shopping mall filed for bankruptcy.

Various Capital Structure Theories

The emphasis on the CS management is very clear. There are different approaches to CS management which are as follows.

1. Net income theory
2. Net Operating income theory
3. Traditional theory
4. MM model

Net Income theory states that by reducing the cost of capital the firm market value increases. Which means that a company can select a CS where debt can be more than equity, thus to increase the value of the company.

Net Operating Income approach proposes the cost of capital and the market value of company debt are independent from the extent of leverage utilized by the company. Which means CS is irrelevant to value of company.

The traditional approach implies that the cost of capital is related to the changes in cost of equity and debt. It’s reasonable favorably to certain limits but if it exceeds then...

References: • Business ratios and formulas: a comprehensive guide, 2007, By Steven M. Bragg
• Financial analysis: tools and techniques: a guide for managers, 2001, Erich A
• Financial management: theory and practice, 2008, Eugene F. Brigham, Michael C. Ehrhardt
• Financial statement analysis: the investor 's self-study guide to interpreting & analyzing financial statements, 1994, Charles J
• Determinants of Capital Structure: Empirical Evidence from the Czech Republic by Patrik BAUER, Finance a .v皞 – Czech Journal of Economics and Finance, 54, 2004.
• Sensitivity of Performance to Capital Structure by Ishola Rufus Akintoye, European Journal of Social Sciences – Volume 7, Number 1 (2008)
• Finding the Right Financing Mix: The Capital Structure Decision by Aswath Damodaran (Presentation)
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