Question

Explain the idea of 'Capital structure'.

Hint:

{Capital Structure = Mix of Debt and Equity}
Debt is cheaper but risky; Equity is costlier but safe.
Goal: Find the right balance to maximize firm value.

Answer 1

Definition: Capital structure refers to the mix or composition of different sources of long-term funds that a company uses to finance its overall operations and growth. It represents the proportion of debt (borrowed funds) and equity (owner's funds) in the total capitalization of the firm. Key Components of Capital Structure:

• Equity Capital:
  • Funds contributed by owners/shareholders
  • Includes equity share capital, preference share capital, retained earnings
  • Features: Permanent capital, no fixed obligation to pay returns, shareholders have voting rights
• Debt Capital:
  • Borrowed funds from various sources
  • Includes debentures, bonds, loans from financial institutions, term loans
  • Features: Fixed obligation to pay interest, repayment schedule, lenders have no voting rights

Factors Affecting Capital Structure:

Factor	Description
Cost of Capital	Debt is cheaper due to tax benefits, but equity is costlier
Risk	Higher debt increases financial risk (fixed obligations)
Control	Issuing more equity dilutes control of existing shareholders
Flexibility	Ability to raise funds in future
Trading on Equity	Using debt to increase returns to equity shareholders
Cash Flow	Ability to meet fixed interest payments
Tax Rate	Higher tax rates make debt more attractive (interest is tax deductible)

Theories of Capital Structure:

• Net Income Approach: Change in capital structure affects value of firm
• Net Operating Income Approach: Capital structure does not affect value
• Modigliani-Miller Theory: In perfect markets, capital structure is irrelevant
• Trade-off Theory: Balance between tax benefits of debt and bankruptcy costs
• Pecking Order Theory: Firms prefer internal funds, then debt, then equity

Optimal Capital Structure: The optimal capital structure is the mix of debt and equity that maximizes the firm's value while minimizing its cost of capital. It balances risk and return. Importance of Capital Structure:

• Affects profitability and financial risk
• Influences cost of capital
• Impacts shareholder wealth
• Determines financial flexibility
• Affects credit rating and borrowing capacity

Example: If a company has total long-term funds of ₹10 crore, with ₹6 crore from equity and ₹4 crore from debt, its capital structure is 60% equity and 40% debt (debt-equity ratio of 2:3).