Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that
make up capitalization. It is the mix of different sources of long-term sources such as
equity shares, preference shares, debentures, long-term loans and retained earnings.
Financial Structure
The term financial structure is different from the capital structure. Financial structure
shows the pattern total financing. It measures the extent to which total funds are available
to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and
capital structure
1. Financial Structure includes both long-term and short-term sources of funds while
Capital structure includes only the long-term sources of funds. 2. Financial structure
means the entire liabilities side of the balance sheet while Capital structure means only
the long-term liabilities of the company. 3. Financial structures consist of all sources of
capital while Capital Structure consist of equity, preference and retained earning capital.
4. Financial Structure will not be more important while determining the value of a firm
while Capital Structure It is one of the major determinations of value of the firm.
Objectives of Capital Structure
The objectives of capital structure revolve around determining the optimal mix of debt
and equity to maximize a firm's value while minimizing risks and costs. Here are the key
objectives:

1. Maximization of Shareholder Wealth – The capital structure should aim to

enhance the company's market value, benefiting shareholders.

2. Minimization of Cost of Capital – By balancing debt and equity efficiently, a firm

can reduce its overall cost of capital (WACC).

3. Financial Flexibility – The structure should allow the firm to raise funds easily for
future growth opportunities without excessive financial strain.
 4. Risk Management – A well-structured capital mix helps in managing financial
risks by avoiding excessive reliance on debt, which can lead to bankruptcy.

5. Profitability and Earnings Stability – An optimized capital structure ensures that

interest payments do not overly burden profits, leading to stable earnings.

6. Maintaining Control – Too much reliance on equity financing can lead to dilution
of ownership and loss of control, while debt financing keeps control with existing
owners.

7. Ensuring Liquidity and Solvency – The company should maintain a balance

where it can meet its short-term and long-term obligations without liquidity crises.

8. Tax Efficiency – Since interest expenses on debt are tax-deductible, firms can
strategically use debt to reduce tax liability.
Forms of Capital Structure

The forms of capital structure refer to the different ways a company can arrange its mix
of debt and equity financing. Here are the main types:

1. Equity Financing Only (Unlevered Capital Structure)

o The company is entirely financed by shareholders' funds (common and
preferred equity).
o No debt is used, reducing financial risk but possibly leading to a higher cost
of capital.
2. Debt Financing Only
o The company relies solely on borrowed funds (bonds, loans, debentures).
o This is rare due to high financial risk and potential bankruptcy if cash flow
is insufficient to cover interest payments.
3. Equity-Heavy Capital Structure
o The firm uses a mix of debt and equity but leans more towards equity.
o This reduces financial risk but might lead to ownership dilution and a
higher cost of capital.
4. Debt-Heavy Capital Structure
o The company uses a significant amount of debt financing while keeping
equity lower.
o This can reduce the cost of capital due to tax benefits on interest payments
but increases financial risk.
5. Balanced Capital Structure (Optimal Mix of Debt & Equity)
o A well-balanced mix of debt and equity that minimizes the Weighted
Average Cost of Capital (WACC).
o Ensures financial flexibility, tax benefits, and risk control.
6. Hybrid Capital Structure
 o A mix of various forms of financing, including common stock, preferred
stock, convertible bonds, and mezzanine financing.
o Provides flexibility while balancing risk and return

Factors Determining Capital Structure

The factors determining capital structure influence how a company decides on the mix of
debt and equity financing. Here are the key factors:

1. Financial Performance & Profitability-Highly profitable firms can use retained earnings
and may not need much debt. Firms with stable earnings can handle more debt due to
their ability to meet interest payments.

2. Cost of Capital- Companies aim to minimize the Weighted Average Cost of Capital
(WACC). Debt is cheaper than equity due to tax benefits, but too much debt increases
financial risk.

A firm must take careful steps to reduce the cost of capital.

(a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon
the nature of the business. If the business consists of long period of operation, it will apply
for equity than debt, and it will reduce the cost of capital.

(b) Size of the company: It also affects the capital structure of a firm. If the firm belongs
to large scale, it can manage the financial requirements with the help of internal sources.
But if it is small size, they will go for external finance. It consists of high cost of capital.

(c) Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are restricted to
raise funds from some sources.

(d) Requirement of investors: In order to collect funds from different type of investors, it
will be appropriate for the companies to issue different sources of securities

3. Business Risk-Industries with stable demand (e.g., utilities) can afford higher debt.
Businesses with volatile earnings (e.g., startups, tech firms) prefer equity to avoid
financial distress.
4. Cash Flow Position- Firms with strong cash flows can support higher debt levels. Weak
cash flow firms may avoid debt to reduce the risk of default.

5. Growth & Expansion Plans- High-growth companies prefer equity financing to avoid
excessive interest obligations. Established firms with predictable revenues may use more
debt.

6. Control Considerations-Owners may avoid issuing more equity to prevent dilution of

control. Debt financing allows founders to maintain control while raising funds.

7. Market Conditions- In a booming stock market, companies may prefer issuing equity.

During economic downturns, debt may be more attractive if interest rates are low.

8. Tax Considerations-Interest on debt is tax-deductible, making debt financing attractive.

Firms in high-tax brackets may prefer debt to maximize tax benefits.

Capital Structure Theories

Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as
the total value of the firm. According to this approach, use more debt finance to reduce
the overall cost of capital and increase the value of firm.

Net income approach is based on the following three important assumptions:

1. There are no corporate taxes.

2. The cost debt is less than the cost of equity.

3. The use of debt does not change the risk perception of the investor

Net Operating Income (NOI) Approach

According to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the overall cost of
capital.
NI approach is based on the following important assumptions;
1.The overall cost of capital remains constant;

2.There are no corporate taxes;

3.The market capitalizes the value of the firm as a whole;

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm does not affect
the market value of a firm in a perfect capital market. Modigliani and Miller approach is
based on the following important assumptions:

• There is a perfect capital market.

• There are no retained earnings.

• There are no corporate taxes.

• The investors act rationally.

• The dividend payout ratio is 100%.

• The business consists of the same level of business risk.