WHAT IS CAPITAL STRUCTURE

One of the most important concern of a firm is to raise funds but there are some decisions need to be taken like thinking about the sources from where the funds need to be raised.

Sometimes, a firm prefer to raise funds from different sources in calculated proportions so that maximum fund can be raised and total cost of raising can be minimized. for eg- a firm needs 100000 bucks and after proper calculations it is suggested that firm should raise 30000 from one source and remaining from other.

If we categorise on the basis of ownership, the main sources are owner’s funds and borrowed funds.

Owner’s funds consists of equity share capital, preference share capital, retained earnings, surpluses etc.

Borrowed funds comprises of  bank loans, debentures, public deposit etc. The providers are banks, debentures holders.

So, on this part we can define CAPITAL STRUCTURE as a mix between owners and borrowed funds. It can be obtained as ratio of debt and equity.

Both Debt and Equity differ significantly with respect to cost and risk.

Cost of debt is lower than cost of equity, because it is observed that lender’s risk is less than equity shareholders risk. This is because the provider will get an assured return for funds lended along with proper  interest, also it gonna benefit firm as intrerest paid is a deductible expense while computing tax liability and dividends are paid after tax profit.

Now, if we look from the risk angle we can say that debt is more risky than equity because debt is an outsider or a third party money which needs to be repayed with proper interest and ultimately it becomes a liability for the firm, whereas the equity repayment is not a cumplusion.

Thus, a lot use of debt can increase financial risk (that firm will not be able to repay its obligations) and hence there required a proper balance between debt and equity.

Therefore, capital structure of a firm affects its profitability and financial risk. An optimal Capital Structure is when there is accurate balance between debt and equity so that it will add to the value of equity share of the firm.

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