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Capital Structure: Meaning and Concept

Prerequisites

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1. Definition

Capital Structure refers to the mix or proportion of different sources of long-term finance (equity, preference shares, debentures, long-term loans) used by a company.

Simple Definition: It is the combination of debt and equity in a company's long-term financing.

2. Components of Capital Structure

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Note: Working capital (short-term sources like trade credit, bank overdraft) is NOT part of capital structure.

3. Capital Structure vs Financial Structure

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Relationship: Capital Structure ⊂ Financial Structure (subset)

4. Importance of Capital Structure

4.1 Affects WACC

  • Optimal capital structure minimizes Weighted Average Cost of Capital
  • Lower WACC → Higher firm value

4.2 Affects Risk and Return

  • More debt → Higher financial risk BUT lower cost (tax shield)
  • More equity → Lower risk BUT higher cost

4.3 Affects Control

  • Debt → No dilution of ownership control
  • Equity → Dilutes existing shareholders' control

4.4 Affects Flexibility

  • High debt → Less flexibility for future borrowing
  • Balanced structure → More financial flexibility

4.5 Affects Firm Value

  • Graham & Dodd: "Right capital structure maximizes market value of firm"
  • Wrong mix can destroy shareholder wealth

5. Patterns of Capital Structure

Different industries have different typical capital structures:

Capital-Intensive Industries (High Debt):

  • Steel, Cement, Power, Telecom
  • Large fixed assets → Can provide collateral → More debt feasible

Service Industries (Low Debt):

  • IT, Consulting, Education
  • Few fixed assets → Less collateral → More equity reliance

Example:

Steel Company: Debt 60%, Equity 40%
IT Company: Debt 10%, Equity 90%

6. Capital Structure Representations

6.1 Debt-Equity Ratio

Debt-Equity Ratio = Total Debt / Total Equity

Example: Debt ₹60L, Equity ₹40L D/E Ratio = 60/40 = 1.5:1 or 1.5

Interpretation: For every ₹1 of equity, company has ₹1.50 of debt

6.2 Debt Ratio

Debt Ratio = Total Debt / Total Assets

Example: If Total Assets = ₹100L, Debt = ₹60L Debt Ratio = 60/100 = 0.60 or 60%

6.3 Equity Ratio

Equity Ratio = Total Equity / Total Assets

Always: Debt Ratio + Equity Ratio = 1 (or 100%)

7. Optimal Capital Structure

Definition: The capital structure that maximizes the firm's value (or minimizes WACC).

Characteristics:

  • Balances tax benefits of debt with bankruptcy costs
  • Provides adequate return to equity holders
  • Maintains financial flexibility
  • Keeps risk at acceptable level

Not a Fixed Formula: Varies by:

  • Industry
  • Company size
  • Growth stage
  • Risk appetite

Exam Pattern Questions and Answers

Question 1: "Define Capital Structure and distinguish it from Financial Structure." (6 Marks)

Answer:

Definition (2 marks): Capital Structure refers to the mix or proportion of long-term sources of finance used by a company to fund its operations and growth. It represents the relationship between different types of permanent capital, primarily debt (debentures, long-term loans) and equity (equity shares, preference shares, retained earnings).

Distinction (4 marks):

Capital Structure:

  • Covers only long-term financing sources
  • Includes equity shares, preference shares, debentures, and long-term loans
  • Represents the permanent funding mix of the company
  • Narrower concept focusing on strategic financing decisions

Financial Structure:

  • Covers both short-term AND long-term financing
  • Includes everything in capital structure PLUS current liabilities like trade creditors, bank overdraft, outstanding expenses
  • Represents the entire liabilities side of the balance sheet
  • Broader concept encompassing all sources of funds

Relationship: Financial Structure = Capital Structure + Current Liabilities

Question 2: "Why is capital structure decision important?" (4 Marks)

Answer: Capital structure decisions are critical because:

  1. Impact on WACC: The debt-equity mix directly affects the weighted average cost of capital. Optimal structure minimizes WACC and maximizes firm value.
  2. Risk-Return Trade-off: More debt increases financial risk (fixed interest obligations) but provides tax shield benefits, while more equity is safer but costlier.
  3. Control Considerations: Debt financing doesn't dilute ownership, while issuing more equity reduces existing shareholders' control.
  4. Financial Flexibility: The chosen structure affects the firm's ability to raise additional funds in future. Excessive debt limits future borrowing capacity.

Summary

Capital Structure:

  • Mix of debt and equity (long-term)
  • Affects: WACC, Risk, Control, Flexibility, Firm Value

Key Concepts:

  • Capital Structure ⊂ Financial Structure
  • Optimal CS minimizes WACC, maximizes value
  • Varies by industry and company

Ratios:

  • D/E Ratio = Debt/Equity
  • Debt Ratio = Debt/Assets

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