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What is Capital Structure?

It is how a firm finances its overall operations and growth by using

different sources of funds.
It is essentially concerned with how the firm decides to divide its cash
flows into two broad components, a fixed component that is earmarked
to meet the obligations toward debt capital and a residual component
that belongs to equity shareholders1

Sources of Capital Structures

The importance of designing a proper capital structure is explained

1. Value Maximization:
Capital structure maximizes the market value of a firm, i.e. in a firm
having a properly designed capital structure the aggregate value of
the claims and ownership interests of the shareholders are
2. Cost Minimization:
Capital structure minimizes the firms cost of capital or cost of
financing. By determining a proper mix of fund sources, a firm can
keep the overall cost of capital to the lowest.
3. Increase in Share Price:
Capital structure maximizes the companys market price of share by
increasing earnings per share of the ordinary shareholders. It also
increases dividend receipt of the shareholders.
4. Investment Opportunity:
Capital structure increases the ability of the company to find new
wealth- creating investment opportunities. With proper capital
gearing it also increases the confidence of suppliers of debt.
5. Growth of the Country:
Capital structure increases the countrys rate of investment and
growth by increasing the firms opportunity to engage in future
wealth-creating investments.

Capital Structure Ratio: Deb-Equity Ratio


It is a ratio that will show you how much of the companys equity is
composed of debt.

The Debt-Equity ratio is an important tool of financial analysis to appraise

the financial structure of a firm. It has important implications from the
view point of the creditors, owners and the firm itself. The ratio reflects
the relative contribution of creditors and owners of business in its
financing. A high ratio shows a large share is 1of financing by the
creditors of the firm; a low ratio implies a smaller claim of creditors. The
debt-equity ratio indicates the margin of safety to the creditors.

Notes: if the debt-equity ratio is high,the owners are putting up relatively

less money of their own. It is danger signal for the creditors. If the project
should fail financially, the creditors would lose heavily. Moreover, with a
small financial stake in the firm, the owners may behave irresponsibly and
indulge in speculative actitivity. If they are heavily involved
financially,they will strain every nerve to make the enterprises a success.
I belief, the greater the debt-equity ratio, the greater is the risk to the

--------------EXAMPLE #1 and EXAMPLE #2 (EXPLAIN)--------------------

*Effect of Debt in Capital Structure (TABLE)

- explain
- The main benefit of increased debt is the increased benefit from the
interest expense as it reduces taxable income.

With an increased debt load the following occurs:

Interest expense rises and cash flow needs to cover the interest
expense also rise.
Debt issuers become nervous that the company will not be able to
cover its financial responsibilities with respect to the debt they are

The Advantages and Disadvantages of Debt and Equity Financing

Debt Advantages
Debt financing allows you to pay for new buildings, equipment and other assets used to
grow your business before you earn the necessary funds. This can be a great way to pursue
an aggressive growth strategy, especially if you have access to low interest rates. Closely
related is the advantage of paying off your debt in installments over a period of time.
Relative to equity financing, you also benefit by not relinquishing any ownership or control of
the business.

Debt Disadvantages
The most obvious disadvantage of debt financing is that you have to repay the loan, plus
interest. Failure to do so exposes your property and assets to repossession by the bank.
Debt financing is also borrowing against future earnings. This means that instead of using all
future profits to grow the business or to pay owners, you have to allocate a portion to debt
payments. Overuse of debt can severely limit future cash flow and stifle growth.
Related Reading:

The Advantages of Issuing Stock as a Form of Equity

Equity Advantages
Equity financing doesn't have to be repaid. Plus, you share the risks and liabilities of
company ownership with the new investors. Since you don't have to make debt payments,
you can use the cash flow generated to further grow the company or to diversify into other
areas. Maintaining a low debt-to-equity ratio also puts you in a better position to get a loan
in the future when needed.

Equity Disadvantages
By taking on equity investment, you give up partial ownership and, in turn, some level of
decision-making authority over your business. Large equity investors often insist on placing
representatives on company boards or in executive positions. If your business takes off, you

have to share a portion of your earnings with the equity investor. Over time, distribution of
profits to other owners may exceed what you would have repaid on a loan.