Capital Structure: Definition, Assumptions and Classification

After reading this article you will learn about Capital Structure:- 1. Introduction to Capital Structure 2. Definitions of Capital Structure 3. Assumptions 4. Classification.

Introduction to Capital Structure:

Capital structure refers to the permanent financing of the company, represented by owned capital and loan/debt capital (i.e.. Preferred Stock, Equity Stock, Reserves and Long- term Debts). In other words, it includes all long-term funds invested in the business in the form of Long-term Loans, Preference Shares and Debentures, including Equity Capital and Reserves.

As regards capital structure, the significant point to be noted is the proportion of owned capital and borrowed capital by way of different securities to the total capitalisation for raising finance.

Long-term funds can be raised either by the issue of:

(a) Shares or

(b) Debentures or long-term loans and borrowings.

However, there is an important difference between the two. If funds are raised by the issue of equity shares, it requires dividends only if there is sufficient profits, whereas, in the latter case, it requires a fixed rate of interest irrespective of the profit or loss. Thus, the question of capital gearing arises as to on which fund a fixed rate of interest or dividend is paid.

Definitions of Capital Structure:

In order to explain the theories of capital structure we are to use the following systems in addition to the above assumptions.

They are:

S = total market value of the equity

T = total market value of the debt

V = total market value of the firm (i.e., S + T)

I = total interest payable on debt capital

NOI/EBIT = net operating incomes available to the equity shareholders

The above equations are used by all capital structure theories, only the controversy lies in relation to the degree of leverage of the variable cost of equity (K_e), weighted average cost of capital (K_w) and total firms value (V).

Capital Gearing:

Capital gearing stands for the determination of proportion of various kinds of securities to the total capitalisation. The gearing may be high, low or even. When the proportion of Equity Share capital is high in comparison with other securities in the total capitalisation, it is called low geared, and, in the opposite case, it is high geared and at the same time, if the Equity Share Capital is equal to the other securities, it is called evenly geared.

Thus, the capital gearing ratio is the ratio between Equity Share Capital and Fixed Interest Bearing Securities:

Thus, from the above, it is quite clear that the capital structure of Company X is low-geared, Company Y is evenly geared and Company Z is high geared. The higher the gear, the more speculative will be the character of equity shares, since, under this condition, dividend on equity fluctuates disproportionately with the amount of divisible profits.

That maximisation of shareholder’s wealth depends on some basic decisions. In order to maximise the value of the equity shares, the firm must have to choose a financing mix-capital structure which will assist to achieve the desired objectives. Thus, the capital structure must be tested from the point of view of its effect towards the value of the enterprise.

It is needless to mention that a firm must choose its financing-mix in such a manner so that it maximises the shareholders’ fund if the capital structure of the firm affects the total value of the enterprise which, in other words, goes by the name of Optimum Capital Structure for the firm.

According to Solomon, E, the same is defined as ‘that capital structure or combination of debt and equity that leads to the maximum value of the firm’. Thus, we cannot ignore the importance of capital structure of a firm as we believe that there is a clear relationship between the value of the firm and the capital structure although some others do not accept it.

From theoretical point of view capital structure affects either cost of capital or expected yield or both of a firm. On the contrary, financing-mix affects the yield per share which belongs to the equity shareholders but do not affect the total earnings since, they are determined by investment decisions of a firm.

In other words, the decisions of capital structure affect the value of the firm by the returns that are made available for the equity shareholders. On the other hand, leverage affect the value of the firm by the cost of capital.

Assumptions of Capital Structure:

The relationship between the Capital Structure and the Cost of Capital can better be understood if we assume the following:

(i) Two types of capital viz, debt and equity are employed;

(ii) Total assets of the firms must be presented;

(iii) Regularity of paying 100% dividends to the shareholders;

(iv) The operating incomes may not be expected to grow further;

(v) Business risk should be constant;

(vi) There will not be any income tax; and

(vii) Investors should bear the same subjective probability distribution relating to future operating income;

(viii) The firm must enjoy a perpetual life.

Financial Structure and Capital Structure:

The financial structure of a firm comprises the various ways and means of raising funds.’ In other words, financial structure includes all long-term and short-term liabilities. But if short-term (i.e. current liabilities) liabilities are excluded the same is known as net worth or capital structure.

It is needless to mention that the difference between the financial structure and the capital structure lies on the treatment of current liabilities/short-term borrowings Thus, instead of exclusion of current liabilities, if they are included, which is quite justified for a broader sense of the term, there will be no difference between the two.

Classification of Capital Structure:

We know that a firm obtains its requirement from various sources and invest the same also in various forms of assets.

In other words, a firm has to perform a two-fold aspect for its capital structure application, viz,

(i) The sources of funds and

(ii) The application of such funds.

Thus, the classification of capital structure can be represented as under:

(i) According to Sources;

(ii) According to Ownership;

(iii) According to Cost; and

(iv) According to nature and type.

(i) According to Sources:

It may be recalled that the sources are of:

(i) Internal

(ii) External Capital.

(ii) According to Ownership:

According to ownership, capital is divided into:

a. Owned Capital and

b. Borrowed Capital.

(iii) According to Cost:

According to cost, however, capital structure is classified into:

a. Fixed Cost Capital and

b. Variable Cost Capital.

(iv) According to nature or type:

There are two types of capital structure according to the nature and type of the firm, viz, (a) Simple and (b) Complex.

a. Simple:

When the capital structure is composed of Equity Capital only or with Retained earnings, the same is known as Simple Capital Structure.

Illustration:

b. Complex:

When Capital structure composed of more than one source or identical nature, the same is known as Complex Capital Structure In other words, if the capital structure is composed of Equity Share Capital, Preference Share Capital, Retained Earnings, Deben­tures, Long-term Loans and Current Liabilities etc., the same is known as complex capital.

Illustration:

In practice, however, the so called ‘Simple’ form is not possible. Although a firm may start with the “Simple” type, the same is converted into a “Complex” one in course of time