- Capital structure of a firm is a reflection of the overall investment and financing strategy of the firm.
- Capital structure can be of various kinds as described below:
§ Horizontal capital structure: the firm has zero debt component in the structure mix. Expansion of the firm takes through equity or retained earnings only.
§ Vertical capital structure: the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built.
§ Pyramid shaped capital structure: this has a large proportion consisting of equity capita; and retained earnings.
§ Inverted pyramid shaped capital structure: this has a small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt.
SIGNIFICANCE OF CAPITAL STRUCTURE:
- Reflects the firm’s strategy
- Indicator of the risk profile of the firm
- Acts as a tax management tool
- Helps to brighten the image of the firm.
FACTORS INFLUENCING CAPITAL STRUCTURE:
- Corporate strategy
- Nature of the industry
- Current and past capital structure
CAPITAL STR. V/S FINANCIAL STR.:
- CS relates to long-term capital deployment for creation of long-term assets. FS involves creation both long term and short term assets.
- CS is the core element of the financial structure. CS can exist without the current liabilities and in such cases; CS shall be equal to the financial structure.
- FS of a firm is considered to be a balanced one if the amount of current liabilities is less than the capital structure net outside debt because in such cases the long-term capital is considered sufficient to pay current liabilities in case of sudden loss of current assets.
- Components of the CS may be used to build up the level of current assets but the current liabilities should not be used to finance acquisition of fixed assets.
PLANNING AND DESIGNING OF CAPITAL STRUCTURE:
- Attributes of a well planned capital structure
- Designing a capital structure
- Design should be functional
- Design should be flexible
- Design should be confirming statutory guidelines
DETERMINANTS OF CAPITAL STRUCTURE:
- Minimization of risk
- Maximization of profit
- Nature of the project
- Control of the firm
COST OF CAPITAL:
Factors determining cost of capital:
- General economic conditions: fluctuations in interest rates occur as a result of changes in the demand supply equilibrium of ingestible funds.
- Risk profile of the project: a project considered risky would attract capital at a higher cost than a project in the same industry having lesser risk.
COST OF DEBT:
- Concerned essentially with the long-term debt of the firm.
- The long-term debt has been used to finance long-term projects.
- We denote cost of debt by the symbol k (d). It is calculated in different ways depending upon whether the debt is a rolling or a term debt redeemable at the expiry of the term.
COST OF PREFERENCE SHARE CAPITAL:
- The preference dividend is akin to the interest payment and redemption of preference capital is equivalent to redemption of debt.
- Its inclusion in the share capital component is primarily done to bring down the borrowings of the firm in the balance sheet.
- Cost of preference share capital is arrived at by equating the aggregate of present value of the periodic dividend payments and the redemption amount.