What is Capital Structure?

Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.

Optimal Capital Structure

The two widely used funding options for an organization are debt and equity. Depending on an organization's objectives and various other factors, a finance manager will decide whether to use debt or equity or a combination of both in order to have an optimal capital structure. An optimal structure is something that has the minimum weighted average cost of capital.

Importance of Capital Structure

• A firm having a sound capital structure implies that the capital of the firm is used effectively. This helps in preventing over or under-capitalization.
• A good capital structure creates flexibility to either increase or decrease debt as needed.
• A proper capital structure serves dual purposes: maximizing the shareholder value and reducing the cost of capital.
• An effective capital structure also helps the company to increase its profits through high stakeholder returns.

Dynamics of Debt and Equity

• Debt holders generally take fewer risks because they are the first owner of the company assets if the company goes bankrupt.
• Equity investors, on the other hand, take higher risks, as they receive only the remaining profits after paying the debt holders. But, in exchange for assuming these higher risks, equity investors expect higher returns from the firm as a result. This implies that the cost of equity is higher than that of debt.

Financial Leverage

The term financial leverage refers to the ratio of debt in the firm's total capital. Also known as capital gearing, a firm with a high debt level is known as highly levered, and a firm that has a low debt level is called a low levered firm.

Factors Influencing Capital Structure

• Control: This is one of the factors which influence the capital structure of the organization. The type of shareholders and their voting rights will influence the firm's capital.
• Government: Government policies, like monetary and fiscal policies, can bring changes in the capital structure decisions of the organization.
• Cost of capital: The total cost of capital for a firm is the weighted average of both cost of equity and cost of debt, known as the weighted average cost of capital (WACC)

Industry-Based Capital Structures

Capital structure varies depending upon the type of industry an organization is in. Industries like mining don’t prefer debt forms of capital structure, as their cash flows cannot be predicted easily. On the other hand, industries like banking have huge amounts of leverage and hence prefer debt capital.

Recapitalization of a Business

A firm that wants to recapitalize its business must first optimize its capital structure. This can be done by changing the combination of debt and equity.

Some of the options available for recapitalization are:

• Issue debt and repurchase equity: Under this first option, a firm would borrow money by issuing debt and then use the capital in order to repurchase the share from its equity investors. This helps in increasing the amount of debt and reducing the equity in the balance sheet.
• Issue debt and pay the dividend to equity holders: In this option, a firm would borrow money and use it to pay a one-time special dividend. This is another method that helps in reducing equity and increasing debt.
• Issue equity and repay debt: This is a reverse option in which equity is issued through the sale of new shares and the proceeds are used to repay the debt. This is not a preferred approach, as the cost of equity is higher than the cost of debt.

Types of Financing

Equity capital can be divided into the following types:

• Retained earnings: Retained earnings are remaining profits that are kept separately and used for business purposes.
• Contributed capital: This is the amount of money contributed by the owners at the time of commencement of business.

Debt capital can be divided into the following types:

• Long-term bonds: This is considered to be the safest form of debt because they offer an extended repayment period and only interest payment needs to be made, whereas principal is paid only at the time of maturity.
• Short term bonds: This is a short-term debt used by companies in order to meet their short-term requirements.

Pros and Cons of Using Debt Financing

There are several advantages of using debt capital in a business:

• By using debt capital, an organization can easily forecast in advance the amount to be paid every month, as well as the amount to be paid back after the end of the particular period. This can help the company to plan for various other purposes.
• A company that is debt-financed is more responsible because timely payments can help the organization to maintain a good relationship with the provider.
• A company that has a trustworthy payment record also benefits when opting for debt capital.
• Companies using debt also enjoy tax benefits on the interest paid on debt.

Some of the drawbacks of using excess debt level are as follows:

• Some privately owned companies are charged a high interest rate because they report limited information when compared with publicly owned companies.
• Companies opting for excess debt financing may undergo huge financial risks and financial distress, as they may find it difficult to make the repayment.
• By opting for debt financing, a company may face challenges during economic distress.

Debt-to-Equity Ratio

The debt-to-equity ratio is used to evaluate the financial leverage of a firm. It is calculated by dividing the company's liabilities by shareholder's equity. This particular ratio is an important metric used in corporate finance in order to know the extent to which a company uses debt and equity capital.

Modigliani Approach

The Modigliani theorem states that capital structure is not an influencing factor for firm value. This is one of the capital theories. Whether a firm has high leverage or low debt in its financing mix has no effect on its market value.

Context and Applications   

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for:

• B.B.A. in Finance   
• M.B.A. in Finance