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Capital Structure

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Key Highlights

  • Capital Structure is the combination of debt and equity a company employs to finance its growth and operations.

  • Components of capital structure includes equity and debt capital.

What is Capital Structure?

Capital Structure is the combination of debt and equity a company employs to finance its growth and operations. Simply put, it indicates how a company raises funds—borrowing (debt), issuing shares (equity), or a combination of both.

Components of Capital Structure

1. Equity Capital

  • Common Shares: Held by ordinary shareholders with voting rights.

  • Preferred Shares: Shareholders receive fixed dividends but generally don't have voting rights.

  • Retained Earnings: Profits re-invested in the company rather than paid out as dividends.

2. Debt Capital

  • Short-Term Debt: Loans, overdrafts, or commercial paper due within one year.

  • Long-Term Debt: Bonds, debentures, or term loans due over a few years.

  • Convertible Debt: Debt that can be converted into shares at a later date.

Capital Structure Formula

There is no one fixed formula, but one of the ratios most often used to comprehend capital structure is the Debt-to-Equity Ratio:

Debt-to-Equity Ratio = Total Debt/Total Equity

This indicates how much debt a firm employs in comparison to equity. A ratio of 1 signifies that the firm employs equal proportions of debt and equity.

Capital Structure Example

Assume a firm has:

  • ₹30 crore as equity
  • ₹20 crore as debt

Its capital structure is:

  • Equity = 60%
  • Debt = 40%

Why Capital Structure Matters?

1. Risk Management

  • Increased debt translates into increased repayment obligations and increased risk.

  • Increased equity minimizes risk but can dilute ownership.

2. Cost of Capital

  • Debt is less costly (interest is tax-deductible), but excessive increases risk.

  • Equity is costly (dividends are not tax-deductible), but safer.

3. Investor Confidence

  • An optimal capital structure demonstrates financial health and sound governance.

4. Business Flexibility

  • Firms can finance in a manner best suited to their market environment and objectives.

Optimal Capital Structure

There is no single "one-size-fits-all" optimal structure. The optimal capital structure is the combination of debt and equity that:

  • Reduces the cost of capital overall

  • Maximizes the company’s value

  • Maintains financial stability

Capital Structure vs Financial Structure

Capital StructureFinancial Structure
Includes only long-term debt and equityIncludes all liabilities, short-term and long-term
Focused on strategic financingBroader view of company’s liabilities