One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. Most companies plan to raise funds for their capital needs using a judicious mix between owners funds (equity) and borrowed funds (debt). This mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure.
Capital structure of a company, thus, affects both the profitability and the financial risk. it is considered be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. In other words, all decisions relating to capitalstructure should emphasise on increasing the shareholders’ wealth.
Thus, capitalStructure of a company affects the rate of return on owners’ capital (shareholders’ funds). This in turn, determines the earnings per equity share (EPS) and has its effect on the market value of company’s shares. Hence, the choice of an appropriate capitalstructure becomes a very important decision for the finance manager of any company.
Importance of Capital Structure:
- Increase in value of the firm:
- An optimal capital-structure of a company leads to increase the market price of shares, which results in increase in the value of the firm.
- Maximisation of return
- Minimisation of Cost of Capital
- Provides Risk information:
- An analysis of Capital-Structure of Business, can help in determining how risky it is to invest in a business.
Deciding about the capital-structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors. Important factors which determine the choice of capital-structure are as follows:
- Cash Flow Position:
- Return on Investment (RoI):
- Cost of debt
- Tax Rate
- Interest Coverage Ratio (ICR)
- Debt Service Coverage Ratio (DSCR)
- Cost of Equity
- Floatation Costs:
- Risk Consideration
- CapitalStructure of other Companies
Trading on Equity
Trading on Equity Trading on Equity refers to the use of high debt for ensuring higher returns for the equity shareholders. This is workable when the profitability is high and the rate of return on investment of funds is higher than the rate of interest to be paid on the borrowed money.
Situation where income of shareholders is maximised and cost of capital is minimised.