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Capital Structure: Role in efficient financial management

Capital structure refers to the combination of various sources from where the long-term funds which are required for business may be raised. It may be called a ‘capital-mix’ which comprises of equity capital, preference capital and debt capital. Financial management has several objectives, the most important one being maximizing the value of the business.

capital-structureIt thus follows that an optimum capital structure would yield maximum value to the business. Optimality of capital structure may be defined as a point where the value of business is maximum and the cost of raising the funds is minimum.

Following are the characteristics of an efficient capital structure:

(a)  Flexibility: The Company should be able to adjust its capital structure whenever there is a need to do so.

(b)  Liquidity: An efficient capital structure protects the company from becoming insolvent.

(c)  Yield: Earning per share (EPS) is an extremely critical indicator of profitability. An efficient capital structure helps to maximize the EPS and also bring down the overall cost of capital.

(d)  Leverage: Debt component in a capital structure gives a good leverage effect, however the company needs to control debt since it brings payment obligations which may endanger the liquidity position.

(e)  Dilution of control: The capital structure should be such that the owners do not feel that there is a dilution of their control.

Every company has to make a decision as to which component should be included in their capital structure and in what proportion. The three major considerations here are:

  1. Cost
  2. Risk
  3. Control

Let us analyze each of these considerations in terms of capital structure components

Equity Capital

(1)  Cost: Equity capital is the costliest source of capital. The cost of issuing shares, registration, transfer, prospectus and other statutory obligations shoot up the cost of this source. Moreover, shareholders always expect higher dividend than the interest paid to debt holders. Also, in some cases, dividends do not give tax-shield, unlike interest

(2)  Risk: Equity capital is the least risky source since there is no obligation of repayment of capital and dividend

(3)  Control: Issue of equity capital ensures dilution of control since new shareholders get the entry

Preference Capital

(1)  Cost: The rate of dividend is generally higher than the interest rate but lower than the cost of equity capital.

(2)  Risk: It is riskier than the equity capital since dividend has to be mandatorily paid and even the principal part needs to be redeemed after a reasonable period.

(3)  Control: There is no dilution of control since there are limited voting rights.

Debt Funds (Debentures/Loans)

(1)  Cost: Cheaper than the equity and preference capital. Moreover, interest is a tax-deductible expenditure

(2)  Risk: This is the riskiest source of capital, since interest and principal repayment is to be mandatorily and diligently followed.

(3)  Control: There is no dilution of control, except when there is a nominated member from any financial institution which has lent funds to the company

The above three are the most important considerations, although there are several other. The company has to be extremely careful while selecting its capital structure since the future viability of the business will depend of its efficiency. 


Posts by SpeakBindas Editorial Team.

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