Capital Structure

Q.1 What is meant by capital structure.

Ans. Capital structure means the pattern of capital employed in the firm. It is a financial plan of the firm in which the various sources of capital are mixed in such proportions that those provide a distinct capital structure most suitable for the requirement of the firm.

Capital structure represents the mutual proportion between long term sources of capital which includes equity shares, preference shares, reserve & surplus and long term debts.

According to Weston and Brigham:-

“Capital structure is the permanent financing of the firm, represented by long-term debt, preferred stock and net-worth.”

Q.2 Define financial structure, Asset structure and capitalization?

Ans. Financial structure:- refers to the way, the company’s assets are financed. It is the entire left hand side of balance sheet which includes all the long term and short-term sources of capital.

Asset Structure:- Asset structure refers to total assets and their components, It includes all types of assets of the company i.e. fixed assets and current assets.

Capitalization:- Capitalization is a quantitative concept indicating the total amount of long-term finance required to carry on the business capitalization comprises a corporation’s ownership capital and its borrowed capital, as represented by its long - Term indebtedness.

Q.3 What factors should be borne in mind in deciding a capital Structure?

Ans. All the factors which affect its capital structure should be considered at the time of its formation. Generally factors affecting capital structure are divided in two categories, namely (A) Internal factors, and (B) External Factors.

Factors Affecting capital Structure-----

Internal factors--Size of business, Nature of business, Regularity of Income, Assets Structure, Age of Firm, Attitude of Management, Freedom of Working, Desire to control, Future plans, Period and Purpose of Financing ,Operating Ratio,

Trading on Equity

External Factors--Capital Market Conditions ,Nature of Invertors, Policy of financial Institutions, Taxation Policy, Government Control, Cost of Capital, Seasonal Nature, Economic Fluctuations, Nature of competition

Q.4 What is balanced or optimum capital structure? Give essential of Optimum Capital Structure.

Ans. The optimal or the best capital structure implies the most economical and safe ratio between various types of securities. A capital structure of security mix that minimizes the firm’s cost of capital and maximizes firms’ value is called optimal capital structure.

Essentials of Optimum Capital Structure:-

1. Simplicity:- The capital structure should not complicated. Therefore, it is essential that in the beginning only equity shares or preference shares should be issued and afterwards debentures may be issued

2. Flexibility:- The capital structure should suit to the requirement of the firm in both short-term and long-term.

3. Minimum Cost:- A sound capital structure must ensure the minimum cost of capital therefore, while determining the capital structure, such a mix of different securities should be selected in which the cost in minimum.

4. Minimum Risk:- The capital structure should be heart risky. Therefore, sound capital structure attempts at a perfect trade-off between return and risk.

5. Maximum Return:- The appropriate capital structure would be one that is most profitable to the company. It is possible when the cost of financing is minimum and the firm earns stables and adequate income regularly.

6. Maximum Control:- The capital structure should be designed to preserve the control of the company’s management in the hands of existing shareholders. Therefore, additional funds be raised through debentures and preference shares.

7. Safety:- Debt should be used to the extent that the burden of fixed charges does not create the danger of insolvency.

8. Full Utilization:- The amount of capital should be determined in such a way that neither there should be over capitalization or under capitalization.

9. Adequate Liquidity:- The capital structure should be determined in such a way the it may always provide adequate liquidity.

10. Alternative Rules:- The capital structure should be that which provides different sights to the securities holder such as return, voting power, redemption, transfer etc. are more and more attractive.

11. Fulfill Legal Requirements:- The capital structure should fulfill certain rules framed in companies and other acts regarding the ratios of various types of securities in the capital structure of business concerns.