Jai Narayan Vyas University

Jodhpur

Faculty of law

SESSION = 2020-21

SUBJECT = ECONOMICS

TOPIC = CAPITAL STRUCTURE

SUBMITTED BY SUBMITTED TO

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 ACKNOWLDGMENT

I have taken lots of efforts in this assignment. However it would not have been possible
without the kind support of Mr Dr. P.S.Bhati Sir. I would like to express my sincere thanks to
her.

I m highly indebted to jai Narayan vyas university for this guidance and constant supervision
as well as for providing necessary information regarding this assignment.

I would like to express my gratitude towards my family and friends for their kind cooperation
and encouragement which helped me in completing my assingnment.

My thanks also goes to those people who directly or indirectly helped me in completing my
project report.
Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure means

the arrangement of capital from different sources so that the long-term funds needed for the

business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,

preference share capital, debentures, long-term loans, retained earnings and other long-term

sources of funds in the total amount of capital which a firm should raise to run its business.

Few definitions of capital structure given by some financial experts:

“Capital structure of a company refers to the make-up of its capitalisation and it includes all

long-term capital resources viz., loans, reserves, shares and bonds.”—Gerstenberg.

“Capital structure is the combination of debt and equity securities that comprise a firm’s

financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-

term debts, preference share capital and equity share capital including reserves and

surplus.”—I. M. Pandey.

Capital Structure, Financial Structure and Assets Structure:

The term capital structure should not be confused with Financial structure and Assets

structure. While financial structure consists of short-term debt, long-term debt and share

holders’ fund i.e., the entire left hand side of the company’s Balance Sheet. But capital

structure consists of long-term debt and shareholders’ fund.

So, it may be concluded that the capital structure of a firm is a part of its financial structure.

Some experts of financial management include short-term debt in the composition of capital

structure. In that case, there is no difference between the two terms—capital structure and

financial structure.
So, capital structure is different from financial structure. It is a part of financial structure.

Capital structure refers to the proportion of long-term debt and equity in the total capital of a

company. On the other hand, financial structure refers to the net worth or owners’ equity and

all liabilities (long-term as well as short-term).

Importance of Capital Structure:

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and

securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A

properly designed capital structure ensures the determination of the financial requirements of

the firm and raise the funds in such proportions from various sources for their best possible

utilisation. A sound capital structure protects the business enterprise from over-capitalisation

and under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the

from higher return to the equity shareholders that is increase in earnings per share. This can

be done by the mechanism of trading on equity that is refers to increase in the proportion of

the capital structure which is the cheapest source of capital. If the rate of return on capital

employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest

paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through

minimisation of the overall cost of capital. This can also be done by incorporating long-term
debt capital in the capital structure as the cost of debt capital is lower than the cost of equity

or preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt

capital because, at the time of poor earning, the solvency is disturbed for compulsory

payment of interest to .the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that,

according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be

diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,

payment of fixed interest charges and repayment of principal amount of debt in time) will

also increase. A sound capital structure protects a business enterprise from such financial risk

through a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the

higher proportion of debt in capital structure compels the company to pay higher rate of

interest on debt irrespective of the fact that the fund is available or not. The non-payment of

interest charges and principal amount in time call for liquidation of the company.
The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk

factor has an important bearing in determining the capital structure of a company and it can

be avoided if the project is financed by issues equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will be the risk

of variation in the expected earnings available to equity shareholders. If return on investment

on total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest

rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not get

any return at all.

3. Cost of capital:

Cost of capital means cost of raising the capital from different sources of funds. It is the price

paid for using the capital. A business enterprise should generate enough revenue to meet its

cost of capital and finance its future growth. The finance manager should consider the cost of

each source of fund while designing the capital structure of a company.

4. Control:

The consideration of retaining control of the business is an important factor in capital

structure decisions. If the existing equity shareholders do not like to dilute the control, they

may prefer debt capital to equity capital, as former has no voting rights.

5 Trading on equity:

The use of fixed interest bearing securities along with owner’s equity as sources of finance is

known as trading on equity. It is an arrangement by which the company aims at increasing

the return on equity shares by the use of fixed interest bearing securities (i.e., debenture,

preference shares etc.).

on equity shares can be increased by using borrowed capital. This is so because the interest

paid on debentures is a deductible expenditure for income tax assessment and the after-tax

cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate

of return on total capital employed exceeds the rate of interest on debt capital or rate of

dividend on preference share capital, the company is said to be trading on equity.

6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and

lending policies of financial institutions which change the financial pattern of the company

totally. Monetary and fiscal policies of the Government will also affect the capital structure

decisions.

7 Size of the company:

Availability of funds is greatly influenced by the size of company. A small company finds it

difficult to raise debt capital. The terms of debentures and long-term loans are less favourable

to such enterprises. Small companies have to depend more on the equity shares and retained

earnings.

On the other hand, large companies issue various types of securities despite the fact that they

pay less interest because investors consider large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different types of

investors will have to be kept in mind. For example, a poor or middle class investor may only

be able to invest in equity or preference shares which are usually of small denominations,

only a financially sound investor can afford to invest in debentures of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.
9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when

required. Flexibility provides room for expansion, both in terms of lower impact on cost and

with no significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds are

needed for long-term (say 10 years), it should be raised by issuing debentures or preference

shares. Funds should be raised by the issue of equity shares when it is needed permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and

certain earnings prefer debentures or preference shares and companies having no assured

income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital

structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are

required for manufacturing purposes, the company may procure it from the issue of long-

term sources. When the funds are required for non-manufacturing purposes i.e., welfare

facilities to workers, like school, hospital etc. the company may procure it from internal

sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is favourable. This is so because

the dividend payable on equity share capital and preference share capital are not deductible

for tax purposes, whereas interest paid on debt is deductible from income and reduces a

firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds.
Moreover, a company has to pay tax on the amount distributed as dividend to the equity

shareholders. Due to this, total earnings available for both debt holders and stockholders is

more when debt capital is used in capital structure. Therefore, if the corporate tax rate is high

enough, it is prudent to raise capital by issuing debentures or taking long-term loans from

financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate

cash inflows. It analyses solvency position and the ability of the company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered while planning the

capital structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT

is high from EPS point of view, debt financing is preferable to equity. If ROI is less than the

interest on debt, debt financing decreases ROE. When the ROI is more than the interest on

debt, debt financing increases ROE.