Q.6 “Capital structure refers to the mix between owners and borrowed funds.” Explain.
Ans:
Capital structure refers to the mix of owners’ funds (equity) and borrowed funds (debt) that a company uses to finance its operations and growth. This mix is a critical decision in financial management, as it directly impacts the company’s profitability, risk, and overall financial health.
Key Components of Capital Structure:
Owners’ Funds (Equity):
These include equity share capital, preference share capital, and retained earnings (reserves and surpluses).
Equity represents the ownership stake in the company. Shareholders bear the risk of the business and, in return, expect dividends and capital appreciation.
Equity is considered less risky for the company because there is no obligation to repay the funds or pay dividends (in the case of ordinary shares).
Borrowed Funds (Debt):
These include loans, debentures, and public deposits sourced from banks, financial institutions, or the public.
Debt is a liability for the company, as it requires regular payment of interest and repayment of the principal amount.
Debt is cheaper than equity because lenders face lower risk (they earn a fixed return and have priority in repayment). Additionally, interest payments are tax-deductible, reducing the company’s tax liability.
Keywords : Equity Capital, Debt Capital, Cost of capital, Business Risk
Extra Info : Importance of Capital Structure: The proportion of debt and equity in the capital structure affects: Cost of Capital:Debt is cheaper than equity due to lower risk for lenders and tax benefits. However, excessive debt can increase the cost of equity, as shareholders demand higher returns for the increased financial risk.An optimal capital structure minimizes the overall cost of capital, maximizing the company’s value.Financial Risk:Higher debt increases fixed financial charges (interest and principal repayment), raising the risk of default. If a company fails to meet these obligations, it may face liquidation.Equity, on the other hand, does not carry such obligations, making it risk-free for the company.Profitability:Debt can enhance profitability through financial leverage. If the company earns a return higher than the cost of debt, shareholders benefit from increased earnings per share (EPS).However, excessive debt can reduce profitability due to high interest payments and financial distress.Shareholder Wealth:The goal of capital structure decisions is to maximize shareholder wealth. An optimal capital structure balances debt and equity to increase the value of equity shares. Debt-Equity Ratio: The capital structure is often measured using the debt-equity ratio: Optimal Capital Structure: An optimal capital structure is achieved when the mix of debt and equity maximizes the value of the company and minimizes the cost of capital. It ensures that the company can meet its financial obligations while providing adequate returns to shareholders. Conclusion: Capital structure is a crucial aspect of financial management, as it determines the balance between owners’ funds and borrowed funds. While debt is cheaper and can enhance profitability, it also increases financial risk. Equity, though risk-free for the company, is more expensive. Therefore, companies must carefully design their capital structure to achieve an optimal balance that maximizes shareholder wealth and ensures long-term sustainability.
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