Notes On Capital Structure Of A Company:

       In the opinion of Grestenberg, "Capital structure refers to the make up of the firms capitalisation." In other words it represents a mix of different sources of long term funds such as equity shares, preference shares, long term loans, retained earnings etc in the total capitalisation of the company.

Forms or Pattern of Capital Structure:

       The capital structure of the company may consist of the following forms:

  1. Equity Shares only.
  2. Equity Shares and Preference Shares
  3. Equity Shares and Debentures
  4. Equity Shares, Preference Shares and Debentures
Optimal Capital Structure:

       A Firm should to try to maintain an optimal capital structure with the view to maintain the financial stability. The optimum capital structure is obtained when the market value of the share is the maximum.

       It may therefore be defined as the relationship of debt and equity shares which maximizes the value of company's share in the stock exchange.

       In case the company restores to borrowings and the borrowing helped the company to increase the value of shares in the stock exchange, it can be said that the borrowing helped the company to move towards the optimum capital structure. But if the borrowing decreases the market value of the shares, it will be said that the borrowing moved the company from its optimum capital structure. The objective of the firm should therefore be to select debt equity mix which will lead to the maximum equity of the firm.

       The following consideration will help in obtaining optimal capital structure:

  1. The finance manager should take the advantage of financial leverage. In other words, if the Return on Investment is higher than the fixed cost of capital, preference may be given in raising capital having a fixed cost to increase a return on investment.
  2. The financial manager should take the advantage of leverage given by the corporate tax. A high corporate income tax also offers a form of leverage with respect to capital structure management. The higher cost of equity financing can be avoided by the use of debt which in turn provides a higher form of income tax leverage to the equity share holders.
  3. The financial managers should avoid high risked capital structure. This is because if the equity share holders perceive an excessive amount of debt in the capital, the prices of the equity shares will drop.
Optimum Capital Structure and the cost of Capital:

       At the optimum capital structure, the value of equity share is maximum while the value of cot of capital is minimum. The value of equity shares mainly depends upon the earnings per share (EPS). So long, the return on investment (ROI) is more than the cost of borrowings, each rupee of an extra borrowing pushes up the equity per share which in turn pushes up the market value of share. It means that the company can borrow till the interest rate on borrowing equals to or does not exceed the return from the project.

       However each extra rupee of the borrowing increases the risk and therefore inspite of increase in the earnings per share, the market value of shares may fall because the investors may take it as a more risky company. Of course, in some cases, inspite of increase in the risk, the value of company's equity shares may increase because of investors' speculations on future profits.

Features of Optimum Capital Structure:

       The capital structure of the company is said to be optimum if it possess the following features:

1. Profitability:

       The capital structure of the company should be most profitable. The most profitable structure of the company is one that tends to minimize the cost of financing and maximize the earnings per share.

2. Solvency:

       The capital structure of the company should be designed in such a way that the company does not run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company. The debts contents therefore should not be such that it increases the risk beyond the manageable limits.

3. Flexibility:

       The capital structure of the company should be flexible so that it can be adjusted to meet the requirement of the changing situations. Moreover, it should also be flexible for the company to provide funds whenever required to finance a profitable activity.

4. Conservatism:

       The capital structure of the company should not be conservative in the sense that the debts contents in the total capital structure of the company do not exceed the limit which the company cannot bear.

5. Control:

       The capital structure of the company should be such that it involves minimum risk of loss of control of the company.