What is capital structure?
Capital Structure represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, earned revenue, capital surpluses, etc. The term capital structure is used to represent the proportionate relationship between debt and equity.
The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees, customers, creditors, society in general. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced.
Capital structure refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage.
An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision has on an organization’s ability to deal with its competitive environment.
The capital structure of a company is the particular combination of debt, equity and other sources of finance that it uses to fund its long term financing.
The key division in capital structure is between debt and equity. The proportion of debt funding is measured by gearing.
This simple division is somewhat complicated by the existence of other types of capital that blur the lines between debt and equity, as they are hybrids of the two. Preference shares are legally shares, but have a fixed return that makes them closer to debt than equity in their economic effect. Convertible debt may be likely to become equity in the future.
Considering the division between debt and equity is sufficient to understand the issues involved.
Simple financial theory models show that capital structure does not affect the total value (debt + equity) of a company. This is not completely true, as more sophisticated models show. It is, nonetheless, an important result, know as capital structure irrelevance.
The capital a business needs for investing in its assets comes from two basic sources: debt and equity. Managers must convince lenders to loan money to the company and convince sources of equity capital to invest their money in the company. Both debt and equity sources demand to be compensated for the use of their capital. Interest is paid on debt and reported in the income statement as an expense, which like all expenses is deducted from sales revenue to determine bottom-line net income. In contrast, no charge or deduction for using equity capital is reported in the income statement. Rather, net income is reported as the reward or payoff on equity capital. In other words, profit is defined from the shareowners point of view, not from the total capital point of view. Interest is treated not as a division of profit to one of the two sources of capital of the business but as an expense, and profit is defined to be the residual amount after deducting interest. Sometimes the owners’ equity of a business is referred to as its net worth. The fundamental idea of net worth is this:
Net worth = assets − operating liabilities − debt
Net income increases the net worth of a business. The business is better off earning net income, because it’s net worth increases by the net income amount. Suppose another group of investors stands ready to buy the business for a total price equal to its net worth. This offering price, or market value, of the business increases by the amount of net income. Cash distributions of net income to shareowners decrease the net worth of a business, because cash decreases with no corresponding decrease in the operating liabilities or debt of the business.