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Introduction to capital structure

Introduction to capital structure

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Introduction to capital structure Capital structure refers to the way in which a firm is financing its total assets, operations and growth through issuing equity, debt and hybrid securities. Financing is process of collecting money through certain sources to be used on purchasing or maintain total assets, current operations of firm and any expected growth. Equity comes from issuing common stocks, preferred stocks and retained earnings while debt can be classified into long term debt e.g. long te
Introduction to capital structure Capital structure refers to the way in which a firm is financing its total assets, operations and growth through issuing equity, debt and hybrid securities. Financing is process of collecting money through certain sources to be used on purchasing or maintain total assets, current operations of firm and any expected growth. Equity comes from issuing common stocks, preferred stocks and retained earnings while debt can be classified into long term debt e.g. long te

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Published by: Muhammad Mubasher Rafique on Dec 15, 2012
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Introduction to capital structure
Capital structure refers to the way in which a firm is financing its total assets, operationsand growth through issuing equity, debt and hybrid securities. Financing is process of collecting money through certain sources to be used on purchasing or maintain totalassets, current operations of firm and any expected growth. Equity comes from issuingcommon stocks, preferred stocks and retained earnings while debt can be classified intolong term debt e.g. long term note payable, bonds, debenture and short term debt i.e.short term bank loan, account payable. Beside these sources of finance, firms issuesome hybrid securities
 — 
securities that possess the characteristics of both equity anddebt such as income bond.Sources of equity that constitute the equity part of capital structure are quite differentfrom each other. Common stock is major source of equity. Investors who buy commonstock are called common shareholders. If firm earns net profit then it usually paysdividend to common shareholders. Common stocks do not have any maturity. Common
shareholders have voting power to elect firm’s board of directors in this way they enjoy
the control on organization. In the condition of liquidation common shareholder haveclaim on residual value after paying to creditors and preferred stockholders. From abovediscussion we can conclude that common stocks do not have any fixed income andmaturity
 — 
it means after they issued in primary market they can be traded in secondarymarket i.e. stock exchanges, over the counter market.Preferred stock can be defined as category of ownership in a corporation that has moreclaims on total assets and net income than common stock. Preferred stock has fixeddividend at the end each period usually a fiscal year irrespective to whether firm earnsnet profit or not. Some time preferred stock may be regarded as hybrid security becauseit possesses the characteristics of no maturity property of equity and fixed incomeproperty of debt. Unlike common stockholders, preferred stockholders do not have anyvoting power to elect board of directors. Retained earnings are third important source inequity portion of capital structure. Retained earnings refer to the portion of net income
 
that firm reinvests into business. Retained earnings enhance the stake of commonshareholders because it is regarded as property of common stockholders.
 
Debt is amount borrowed by a firm to finance its business by issuing debt instruments.Firms usually pay interest on their debt at the end of each period e.g. annually,semiannually, quarterly etc. Interest is cost of debt for firm and fixed income for creditors. Debt has maturity
 — 
refers to time period until particular debt remainsoutstanding such as a 10-year bond, 20-year bond etc. Debt can be categorized asshort term debt and long term debt. Short term debt is borrowing of firm that havematurity of one year or less such as short term bank loan, T-bill etc, while long termdebt represents the debt that remains outstanding for more than one year for example,note, debenture, bond etc. Debt can also be classified as secured and unsecured debt.Secured debt is borrowing that pledge certain asset of firms as a security in condition of financial distress such as collateral. Unsecured debt is borrowing that does not pledgeany asset of firm such as note and debenture (Ross et al 2008). The instruments differ by maturity, interest rate (fixed or floating), currency, seniority, security, and whether thedebt can be converted into equity. Hybrid securities are particular type of securities thatpossess the characteristics of equity and debt i.e. convertible bond, income bond.Convertible bonds are bond that can be converted into equity before maturity and anychange in price of shares affects convertible bond. Income bonds have fixed maturitybut are paid interest if firm earns sufficient income. We regard hybrid securities as debtbecause they possess characteristics of either fixed income that is tax deductible andfixed maturity.
Goals / Principles of Capital Structure Management:
For considering the suitable pattern of capital structure, it is necessary toconsider certain basic principles which are militant to each other. It is necessary to finda golden mean by giving proper weight age to each of them.
(I) Cost Principle:
According to this principle, ideal capital structure should minimize costfinancing and maximize earnings per share. Debt capital is a cheaper form of capitaldue to-two reasons. First, the expectations of returns of debt capital holders are less

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