You are on page 1of 14

(Capital Structure and its importance

)

SUBMITTED TO:
Prof: Muhammad Jameel

SUBMITTED BY:
M.Yasir Riaz

12165

Zubair Mehmood

12160

SUPERIOR UNIVERSITY
LAHORE

Acknowledgement
1

We find no words to say thanks to our Teacher Prof: Muhammad Jameel. guided us towards the way of success. Enabled us to accomplish this work.We at first bow our head before ALLAH Almighty who bestowed his countless blessings upon us. He is the one who enlightened our brains with knowledge and who made Us Capable of completing this Project. Table of Contents 2 . Bless us with courage of facing problems and obstacles.

....................................................................11 References.....7 Difference between Capital Structure and Financial structure.................. 5 Importance of Capital Structure...................................... 4 Features of Capital Structure................................................................ 14 Definition of Capital Structure 3 .............................................................................................................Definition of Capital Structure................................................................................................................................. 11 Optimal Capital Structure with Examples....................................... 4 Components of Capital Structure.............................................................................................................................................................9 Capital Structure Hierarchy....

which includes both long-term and short-term funds. If future cash flows are not sufficient then the cash insolvency can lead to legal insolvency. Profitability A strong capital structure should permit the high use of leverage at a minimum cost so as to provide better profitability and then maximizing earnings per share. where as the common and preferred stock get through a process of issuing shares to share holders. These payments depend on future cash flows. Features of Capital Structure The features of capital structure of a company are as follows: The term capital structure is used to represent the proportionate relationship between the various long-term kinds of capital arrangements.term debt. Debts are generated from the banks and other lending institutions. The debt financing should be only to that level which can be serviced fully and also be paid back. As already explained that the interest is to be paid on debt and the principal sum is also to be paid. Solvency The high debt threatens the solvency and credit rating of the company. if warranted by the changed environment. Conservatism No company should exceed its debt capacity. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. common equity and preferred equity of an organization is known as capital structure. preference shares. equity. capital surplus. The term capital structure is part of financial structure. Control The capital structure should not lead to loss of control in the company. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. specific short-term debt. 4 . and retained earnings.Capital structure means the total of long-term debt. debentures. An appropriate capital structure should incorporate the following features: Feature Flexibility Detail The term flexibility gives the finance manager the ability to alter the firm’s capital structure with a minimum cost and delay. The capital structure of a firm has an essential role to check the financial position of that firm. long.

Components of Capital Structure The components of capital structure which form the capital structure as. The use of excessive debt threatens the solvency of the company. Risk The capital structure should involve minimum risk of financial insolvency. Within the constraints. Stock is ownership Preferred stock gets dividend before common stock and is preferred in the event of a liquidation Debentures are unsecured debt Loan stock pledges shares to secure loan 5 . Capacity The company should have capacity to pay the fixed periodic charges and the installments of principal sum. it should be used cautiously with equity.Feature Detail Return The capital structure of the company should give maximum return to the shareholders. maximum use of the leverage at a minimum cost should be made so as to obtain maximum advantage of trading on equity at minimum cost. The debt capacity of a company depends on its ability to generate cash flows. Since use of debt ads to the risk of the company and shareholders. The debt capacity of the company should not be exceeded.

also called equity financing or share capital. equity capital is listed as stockholders' equity or owners' equity. in contrast to debt capital. The value of equity capital is computed by estimating the current market value of everything owned by the company from which the total of all liabilities is subtracted. It represents the risk capital staked by the owners through purchase of a company's common stock . PREFERENCE SHARE CAPITAL Investors have the opportunity to receive payment first but retain no shareholder privileges RETAINED EARNINGS Profits generated by a company that are not distributed to stockholders as dividends but are either reinvested in the business or kept as a reserve for specific objectives (such as to pay off a debt or purchase a capital asset). On the balance sheet of the company.EQUITY CAPITAL Invested money that. 6 . is not repaid to the investors in the normal business.

PUBLIC DEBT Mortgages or other liabilities which a commercial entity is responsible to pay that back to the lending institutions. the lower the optimal debt ratio. Importance of Capital Structure The capital structure of a company has much importance not only for its financial position but for its operations as well. Debt payments are tax deductible. DEBENTURE A promissory note or a corporate bond which is backed generally the reputation and integrity of the borrower and by the borrower's specific assets. accumulated surplus. earned surplus. equipment. Retained earnings are reduced by losses. only by TERM LOAN Asset based short-term usually for one to five years loan payable in a fixed number of equal installments over the term of the loan. Term loans are generally provided as working capital for acquiring income producing assets like machinery. if a company's tax rate is high using debt as a means of 7 . undistributed earnings. FACTORE Business Risk Company's Tax Exposure DETAIL Excluding debt. As such. accumulated income.A balance sheet figure shown under the heading retained earnings is the sum of all profits retained since the company's inception. accumulated profit. or undivided profits. Factors That Influence a Company's Capital Structure which explain the importance of Capital Structure are as below. and are also called accumulated earnings. The greater the business risk. inventory that generate the cash flows for repayment of the loan. here some factors which directly or indirectly influence capital structure and these make its importance apparent. business risk is the basic risk of the company's operations. See also retention ratio.

Management styles range from aggressive to the conservative. The more conservative a management's approach is. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital. Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. In case the rate of interest on the debt capital is less.Financial Flexibility Management Style Growth Rate Market Conditions Cash Flow Position financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes. Suppose a firm needs to borrow funds for a new plant. Cost of Equity Capital Therefore. so the tax rate also effect on the capital structure. the less inclined it is to use debt to increase profits. the use of the debt capital can be made 8 . Market conditions can have a significant impact on a company's capital-structure condition. the cost of debt decreases. Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. Cost of Debt The capacity of a company to take debt depends on the cost of debt. Return on Investment The greater return on investment of a company increases its capacity to utilize more debt capital. While making a choice of the capital structure the future cash flow position should be kept in mind. more debt capital can be utilized and vice versa. If the rate of tax is high. Tax Rate The rate of tax affects the cost of debt.

Difference between Capital Structure and Financial structure Here under some points which clearly differentiate the Capital Structure and Financial structure are. Both these conditions have their influence on the selection of sources of finance. Meaning of Financial Structure The specific mixture of long-term debt and equity that a company uses to finance its operations. the cost of equity capital starts increasing rapidly. second is pref. 9 . we can say that total fund is financed from share capital and debt. For instance. Fund from these sources are collected and used for buying the long term and short term assets. The main concern for the financial manager of the company is deciding how much money should be borrowed and the best mixture of debt and equity to obtain. Capital structure is influenced by the industry to which a company is related. this financial structure is a mixture that directly affects the risk and value of the business. Stock market conditions refer to upward or downward trends in capital market. banking companies can raise funds by issuing share capital alone. we have to define the capital structure. Whole capital structure is the part of financial structure. Basis of Capital Structure Financial Structure is the base of capital structure. The financial manager also has to find the least expensive sources of funds for the company to use. One is equity share. Meaning of Capital Structure Capital structure is the mixture of long term capital and debt resources. Capital structure is also influenced by government regulations. If even after this level the debt capital is used further. share and third is debenture.Regulatory Framework Stock Market Conditions Capital Structure of Other Companies only to a limited level. not any other kind of security. If more briefly. Check your balance sheet and you will find that there will be 3 main sources of capital.

investment requirement. We can also say the factor which affects the financial structure. long term and working capital requirement.000 Equity Share Capital = $ 70.000 Proffered Share Capital = $ 10. Nature of business.Basis of Financial Structure There are lots of basis of financial structure. cost of capital.000 Retained Earning = 5000 --------------------------------------------Total Long term Fund = $ 115000 --------------------------------------------- Example of Financial Long Term Liabilities = $ 115000 Current Liability = $ 85000 --------------------------------------------Total Liabilities = $ 200000 --------------------------------------------- 10 . type of business. cash flow ability of company and leverage are its main factor which affects it. EXAMPLES: Example of Capital Structure Long term debt =$ 30.

Capital Structure Hierarchy CAPITAL STRUCTURE DEBTS EQUITY BANK LOAN PREFERRED EQUITY CONVERTIBLE BOND COMMON EQUITY HIGH YEILD DEBTS RETAINED EARNING RIGHT SHARE 11 .

OR A company's ratio of short and long term debt should also be considered when examining its capital structure. the most commonly used ones are: Method 1 One method of estimating a company’s optimal capital structure is utilizing the average or median capital structure of the principle companies engaged in the market approach.Optimal Capital Structure with Examples Definition of Optimal Capital Structure The best debt to equity ratio for a firm that maximizes its value. which provides insight into how risky a company is for potential investors. Estimating the Optimal Capital Structure There are numerous ways in which a company’s optimal capital structure can be estimated. the optimal capital structure for a company is one which offers a balance between the ideal debts to equity ranges and minimizes the firm's cost of capital. The main objective of this method is determining the debt level at which the benefits of increased debt does not overshadow the increased risks and potential costs associated with a economically distressed company. This approach is helpful as the appraiser is well aware about which companies are included in the analysis and the degree to which they are related to the subject company Method 2 This method is applied if the risk of a company did not change because of the nature of its capital structure. and a company would wish as much debt as possible. EXAMPLE 12 . as the interest payments are tax deductible and debt financing is always cheaper than equity financing. Capital structure is most often referred to as a firm's debt to equity ratio. Determining an optimal capital is a chief requirement of any firm's corporate finance department.

000.250.000.Optimal Capital Structure: A best debt/equity ratio for a company.000 Total Debts = 15.000 Preferred Equity = 250.000.000.000. A.000 And the equity is.000 = 15.5% This shows the debts equity ratio is favorable because the debts financing is higher than equity and that is cheaper so the capital structure is optimal. Common Equity = 5000. This is the long-term-debt to equity ratio that will minimize the cost of capital.000 Retained Earnings = 3.000 Additional or fresh capital = 600.000/ 10.000 Long term debts = 10.000 Total Equity = 10.000 =1. Short term debts = 500. Debt Equity Ratio indicates what proportion of equity and debt the company is using to finance its assets. XYZ company has want to calculates its debts equity ratio and the data for it is as below its Debts. 13 .

com/groups/importance-capital-structure-in-creating4092220.org/wiki/Capital_structure http://www.murraystate.8) http://econpapers.wikipedia.Khan and P.linkedin.Y.com/notes/financial-management/features-of-anappropriate-capital-structure/ http://www. (page 19.asp http://www.S.managebuddy.svtuition.References A Book.1 to 19.Jain.html 14 .investopedia.k.org/article/eeejbfina/v_3a35_3ay_3a2011_3ai_3a2_3ap_3a3 58-371.org/2013/06/capital-structure-vs-financial-structure.com/terms/c/capitalstructure.htm http://www.repec.133746203 http://campus.htm http://en. FINANCIAL MANAGEMENT (6th edition) by M.edu/academic/faculty/lguin/FIN330/Optimal%20Capital %20Structure.