ASSIGNMENT

ON
“CAPITAL STRUCTURE”

SUBMITTED BY

BHAWANPREET KAUR

MBA 4nd SEC. B

ROLL NO. 16421073

SUBMITTED TO

MR. HARPREET SINGH

SCHOOL OF MANAGEMENT STUDIES

2017-18

PUNJABI UNIVERSITY PATIALA

CAPITAL STRUCTURE
Meaning and Concept of Capital Structure:
The term ‘structure’ means the arrangement of the various parts. So capital structure means
the arrangement of capital from different sources so that the long-term funds needed for the
business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-term
sources of funds in the total amount of capital which a firm should raise to run its business.

IMPORTANCE OF CAPITAL STRUCTURE:

The importance or significance of Capital Structure:
1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A
properly designed capital structure ensures the determination of the financial requirements of
the firm and raise the funds in such proportions from various sources for their best possible
utilisation. A sound capital structure protects the business enterprise from over-capitalisation
and under-capitalisation.

3. Maximisation of return:
A sound capital structure enables management to increase the profits of a company in the
form of higher return to the equity shareholders i.e., increase in earnings per share. This can
be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of
debt capital in the capital structure which is the cheapest source of capital. If the rate of return
on capital employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate
of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through
minimisation of the overall cost of capital. This can also be done by incorporating long-term
debt capital in the capital structure as the cost of debt capital is lower than the cost of equity
or preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt
capital because, at the time of poor earning, the solvency is disturbed for compulsory
payment of interest to .the debt-supplier.

6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt capital so that,
according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business to be
diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,
payment of fixed interest charges and repayment of principal amount of debt in time) will
also increase. A sound capital structure protects a business enterprise from such financial risk
through a judicious mix of debt and equity in the capital structure

Factors That Influence a Company's Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are as follows:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the
business risk, the lower the optimal debt ratio.

As an example, let's compare a utility company with a retail apparel company. A utility
company generally has more stability in earnings. The company has less risk in its business
given its stable revenue stream. However, a retail apparel company has the potential for a bit
more variability in its earnings. Since the sales of a retail apparel company are driven
primarily by trends in the fashion industry, the business risk of a retail apparel company is
much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that
investors feel comfortable with the company's ability to meet its responsibilities with the
capital structure in both good times and bad.

2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a
means of financing a project is attractive because the tax deductibility of the debt payments
protects some income from taxes.

3. Financial Flexibility
Financial flexibility is essentially the firm's ability to raise capital in bad times. It should
come as no surprise that companies typically have no problem raising capital when sales are
growing and earnings are strong. However, given a company's strong cash flow in the good
times, raising capital is not as hard. Companies should make an effort to be prudent when
raising capital in the good times and avoid stretching their capabilities too far. The lower a
company's debt level, the more financial flexibility a company has.

Let's take the airline industry as an example. In good times, the industry generates significant
amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the
industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden,
it may have a decreased ability to raise debt capital during these bad times because investors
may doubt the airline's ability to service its existing debt when it has new debt loaded on top.

4. Management Style
Management styles range from aggressive to conservative. The more conservative a
management's approach is, the less inclined it is to use debt to increase profits. An aggressive
management may try to grow the firm quickly, using significant amounts of debt to ramp up
the growth of the company's earnings per share (EPS).

5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt by
borrowing money to grow faster. The conflict that arises with this method is that the revenues
of growth firms are typically unstable and unproven. As such, a high debt load is usually not
appropriate.

More stable and mature firms typically need less debt to finance growth as their revenues are
stable and proven. These firms also generate cash flow, which can be used to finance projects
when they arise.

6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition.
Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning
that investors are limiting companies' access to capital because of market concerns, the
interest rate to borrow may be higher than a company would want to pay. In that situation, it
may be prudent for a company to wait until market conditions return to a more normal state
before the company tries to access funds for the plant