CAPITAL STRUCTURE | JAIIB AFM NOTES 2023
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Capital structure is a specific composition of equity and debt used by any company to fund the overall operations, functions, and growth of a company where the debt constitutes the borrowed money that is due back to the lender with an interest expense and equity constitutes the ownership right in the company without needing to pay back any investment. The debt-to-equity ratio is helpful in the determination of the riskiness of a company’s borrowing practices.
TYPES OF CAPITAL
Equity capital: The equity capital has the retained and shared capital covered under it.
The amount that reporting companies receive from the transactions with their owners is known as share capital.
Retained earnings are part of the profit that has been kept separately by the organization and which will strengthen the business.
Debt capital: Its money is raised through borrowing from institutions and it has to be replayed after some time. These are considered cheaper and low-risk alternatives for getting finances when compared to equity capital.
OPTIMAL CAPITAL STRUCTURE
Optimal capital structure can be defined as the best combination of equity and debt financing. It is applicable in amplifying the market value while keeping the company’s cost of capital lower.
To minimize the weighted average cost of capital (WACC), one key strategy applied is aiming for the lowest cost mix of financing.
According to some economists, in an efficient market, a firm’s value is unaffected by its capital structure in the absence of taxes, bankruptcy costs, agency costs, and asymmetric knowledge.
It helps maximize the value of a company in the market while at the same time minimizing its cost of capital.
FACTORS DETERMINING CAPITAL STRUCTURE
Cost of capital: Depending on the anticipated rate of return for the suppliers, the cost of acquiring capital will vary. The risk taken on by investors affects this rate. Since ordinary stockholders do not get a fixed rate of dividend, they are most at risk. After preference shareholders receive their dividends, they are compensated. In all cases, the corporation is required to pay interest on the debentures. It encourages more investors to choose bonds and debentures.
Degree of control: Management that doesn’t allow interference from outsiders prefers to not raise the funds from the equity since the equity shareholders right to appoint the directors and also influence the strength of the company’s owner’s stake.
Risk on Capital: The ratio of debt to equity in a company’s capital structure is also influenced by the management’s attitude. Some managers favor adopting a low-risk strategy and using stock shares as a means of raising capital. Other managers prefer to take on a bigger percentage of long-term debt instruments because they are confident in the company’s ability to repay large debts.
Growth and stability of the sales: Businesses with better-earning prospects can afford to fulfil these set financial obligations because debt repayment is periodic and has a fixed interest rate. Conversely, businesses that experience more revenue volatility, such as those in the consumer goods industry, rely more on stock shares to fund their operations.
Nature and size of a firm: small scale may face issues in raising long-term borrowings even upon getting it raised, these have to face high-interest rates and strict repayment conditions.
Corporate tax rate: Investors may stop buying stocks if a government increases the tax rate on gains from stock market investments. In a similar vein, decisions made by businesses will be influenced if changes in government policy have an impact on the interest rate on bonds and other long-term instruments.
|What is the component of the capital structure?
Which of these is the aim of the capital structure?
Which of the above factors helps in determining the capital structure of a firm?
The cost of the company’s funds is known as
The risk that a business isn’t able to meet its debt repayment obligations is known as
https://youtu.be/_gsk1OwU7Is Here you’ll find a comprehensive explanation of the capital structure and also answers to the given questions.
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