CAPITAL STRUCTURE

PLANNING
 DEFINITION
“Capital Structure of a company refers to the
make-up of its capitalization and it includes all
long term capital resources, viz., shares, loans,
reserves and bonds.”
- Gerstenberg
 CAPITAL STRUCTURE
CONSISTS OF:
1. Owned Funds
• It belongs to the proprietors.
• It includes share capital, free reserves and
surplus.
2. Borrowed Funds
• It consists of long term borrowings from outside
sources.
• It consists of debentures, bonds and long term
loans provided by banks and term lending
institutions.
 EQUITY SHARE CAPITAL
• ‘Risk bearing’ capital of the company.
• Shares which do not enjoy special rights in
respect of payment of dividend and repayment
of capital.
• Rate of dividend fluctuates depending upon
the availability of profits.
 ADVANTAGES &
DISADVANTAGES
1. ADVANTAGES:
• It represents a permanent source of finance.
• It does not carry any fixed burden.
• It enhances the creditworthiness of the firm.
2. DISADVANTAGES:
• Its cost is very high.
• Issue of equity to outsiders causes dilution of
control.
 PREFERENCE SHARES
• Shares which enjoy priority in the payment of
dividend as well as in the repayment of capital.
• Preference shareholder are entitled to receive a
fixed rate of dividend.
• Preference shareholder is paid back the capital
before any payment is made to the equity
shareholders.
 TYPES OF PREFERENCE
SHARES
 Participating : Shareholders are
entitled to participate in surplus profits.
 Non-Participating : Shareholders are
entitled to receive only a fixed rate of dividend.
 Redeemable : Returnable
either on discretion of the company or at the end
of a certain period.
 Irredeemable : Non-returnable.
Contd…
Cumulative : The dividend
payable in a year of loss gets carried over to
the next year.
Non-Cumulative : Dividend paid if
sufficient profits are available or else it lapses.
 Convertible : It can be converted
into equity shares of the company at a certain
conversion ratio decided by the company.
 Non-Convertible : It can’t be converted
into ordinary shares.
 ADVANTAGES &
DISADVANTAGES
1. ADVANTAGES:
• Preferential Rights.
• Arrears of unpaid dividend payable.
• Gives flexibility to the company (Redeemable &
convertible).
2. DISADVANTAGES:
• Fixed dividend.
• No control.
 DEBENTURES
• Money received by the issue of debentures is loan.
• Debenture is security issued by a company against
the debt.
• Debenture holders are the creditors of the company.
• Interest on debentures has to be paid even if the
company makes losses.
• Debenture holders have no voting right.
• No dilution of control.
• Less risky for shareholders.
 ADVANTAGES &
DISADVANTAGES
1. ADVANTAGES:
• Regular fixed income.
• Safety and security of investment.
• Liquidity- Easy sale in stock exchange.
• Conversion into shares.
2. DISADVANTAGES:
• No control.
• Fixed return.
 TERM LOANS
• Meaning:
A loan from a bank for a specific amount that has a
specified repayment schedule and a floating interest
rate. Term loans almost always mature between
one and 10 years.
• 3 categories based on pay back period:
– Short term loans
– Medium term loans
– Long term loans
 ADVANTAGES &
DISADVANTAGES
1. ADVANTAGES:
• Cost lower than share capital.
• No dilution of control.
• Backed by security.
2. DISADVANTAGES:
• No voting rights.
• Repayment is obligatory.
 Comparison of Long-term
sources of Finance
Sources of Cost Dilution of Risk
Finance Control
Equity share
Capital HIGH YES HIGH

Preference HIGH NO NEGLIGIBLE

Share capital
Debenture LOW NO NIL
Capital
Term loans LOW NO NIL
 Essentials of an Optimum
Capital Structure
 Flexibility: The capital structure should
facilitate further financing for expansion,
replacement etc..
 Economy: The capital structure must ensure
the maximum use of leverage at minimum cost.
 Solvency: The capital structure must provide
a balance between different securities so that
there is neither excess of debt nor lack of
benefits of using the debt.
Contd…
 Efficiency: The capital structure must ensure
intensive utilization of available resources.
 Simplicity: The capital structure must be made
easy to understand by avoiding doubts and
complexities.
 Safety: The capital structure should ensure safety
in the business by maintaining adequate cash ratio
(liquidity) in the business.
 Control: While designing the capital structure it
should be kept in mind that the controlling position
of present shareholders remains undisturbed.
Patterns in Capital Structure
• Capital Structure with equity shares only.
• Capital Structure with both equity and preference
shares.
• Capital Structure with equity shares and debentures.
• Capital Structure with equity shares, preference
shares and debentures.