Capital structure
What is Capital Structure?
Capital structure is basically a combination of debt and equity which is used by the company to finance its operations and overall growth. Debt is loans or bond issues. Short as well as long debts are considered a part of capital structure. Equity is preferred stock, retained earnings, or common stocks. A firm’s capital structure is expressed as a Debt-to-Equity or even Debt-to-Capital ratio.
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EXPLAIN THE TERMINOLOGY USED IN CAPITAL STRUCTURE –DEBT AND EQUITY
Debt: Debt is the amount of money borrowed from one party to another. It is used by many corporations and individuals. They can make large purchases that they could not afford under normal circumstances. The most common form of debt are loans, mortgages, auto loans, and personal loans. There are two types of debts. They have secured debts and unsecured debts.
Equity: Equity is referred to as shareholders Equity or Owners’ equity (for private companies). It’s the amount of money that would be returned to the company’s shareholders at the time of liquidation. Equity can be found on the company’s balance sheet. The formula for equity is:
Shareholder’s Equity = Total Assets – Total Liabilities.
How it is calculated?
A firm’s total cost of capital is the total weighted average of the cost of equity and the cost of debt which is known as the weighted average of the cost of capital (WACC).
This can be expressed as:
WACC = (E/V x Re) + {(D/V x Rd) x (1-T)}
Where:
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = Total value of capital (equity + debt)
E/V = Percentage of capital that is equity
D/V = Percentage of capital that is debt
Re = Cost of equity (required rate of return)
Rd = Cost of debt (yield to maturity on existing debt)
T = Tax rate.
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HOW CAN INVESTOR’S SEEK OPTIMAL CAPITAL STRUCTURE
The optimal capital structure is the best mix of debt and equity financing which maximizes the company’s market value while minimizes its cost of capital. Due to tax deductibility debt financing offers the lowest cost of capital. The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the WACC (weighted average cost of capital). The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by WACC.
IMPORTANCE OF CAPITAL STRUCTURE
- Increase in the value of the firm – A good capital structure will increase the market price of the shares and securities which in turn will lead to an increase in the value of the firm.
- Utilization of available funds – a sound capital structure will enable the business enterprise to utilize the funds fully. It also ensures that there is the optimal utilization of funds.
- Maximization of returns – If the rate of return on capital employed (shareholder’s funds + long–term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity.
- Flexibility – a sound capital structure provides room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made.
Final Thoughts:
Capital structure is essentially concerned with the firm that how it decides to divide its cash flow into two broad components. The choice matters to a private company as it directly influences the company’s ability to create shareholder value because the balance sheet sets the minimum threshold for a company’s cost of capital. Investments in the business must meet this threshold or the value is destroyed. All business and investment projects need capital to operate.
Author – Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.
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