Introduction - Capital Structure, Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Introduction
Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level of capital, it will earn high profit and they can provide more dividends to its shareholders.

Meaning of Capital Structure 
Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure is the important decision of the financial management because it is closely related to the value of the firm. Capital structure is the permanent financing of the company represented primarily by long-term debt and equity.

Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”.
According to the definition of R.H.Wessel,“The long term sources of fund employed in a business enterprise”.

Financial Structure
The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business.

Financial Structure = Total liabilities
Or

Financial Structure = Capital Structure + Current liabilities
The following points indicate the difference between the financial structure and capital structure.

Example
From the following information, calculate the capitalization, capital structure and financial structures.

Balance Sheet

(i) Calculation of Capitalization

 (ii) Calculation of Capital Structures

 (iii) Calculation of Financial Structure

Optimum Capital Structure
Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm.

Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.
2. Minimize the overall cost of capital

Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance. Normally the following forms of capital structure are popular in practice.

• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.

What Are the Types of Capital Structure?
As you might suspect, there are two main forms or sources of capital for a capital structure: equity capital and debt capital. 

Equity Capital
This is defined as the money put up by the shareholders -- owners of the company. Equity capital itself usually consists of two sources. One is contributed capital, or the money invested in the business by the purchase of shares of stock. The other is ownership and retained earnings, or the profits from previous years kept by the company and used to strengthen its balance sheet or to fund growth, expansion and acquisitions.
Equity capital, however, is seen by many as the most expensive means to use, because of the cost, or the size of return the company must earn to attract investors.

Debt Capital
Debt capital in a company's capital structure refers to borrowed money at work in the business. Debt is considered the cheaper of the two forms of financing capital, because the interest payments on the debt are a tax deductible expense.
Long-term bonds are generally considered the safest kind of debt capital, because the company has years or even decades to come up with the principal while paying only interest until the bond's maturity. Other sources of debt capital can include short-term commercial paper.
The cost of debt capital in the capital structure will depend on the company's balance sheet at the time it issues bonds to lenders. A Triple AAA rated firm can borrow at extremely low rates compared with one with massive amounts of existing debt, which may have to pay 15% or more in exchange for debt capital.
It might seem that the ideal capital structure is where a company is able to finance all its operations and needs with equity, just as a family with enough income can live debt-free. But that means ignoring a factor many of the most successful companies have to also consider in determining their capital structure: the cost of capital.
If you sell a product people need, the debt will be a lower risk than if you rely on a cyclical or boom business and dependent on the boom to continue to fund your operations.
Great managers are able to consistently reduce their weighted average cost of capital by increasing productivity, or seeking out products with a higher return, as examples. This is why highly profitable consumer staples businesses take advantage of long-term debt by issuing corporate bonds.
Optimal capital structure implies that at a particular ratio between debt and equity, the cost of capital is minimal and the value of the firm is maximized.
That way, when a company decides to raise money, it can choose between debt and equity. Using mostly equity to fund the purchase of assets is considered using lower leverage; while using mostly debt is considered higher leverage.

Vendor Financing
Another, less-well-known form of capital besides equity and debt capital, is called vendor financing. Vendor financing occurs when a company can sell goods before having to pay their vendor. This can dramatically increase the company's return on equity, but without costing the company anything up front.

Policy Holder Float Financing
With an auto insurer, for instance, the policy holder "float" represents money not belonging to the firm that it can use and to earn on an investment until it has to pay it out for accidents or medical bills.

What Is an Example of Capital Structure? 
Let's consider two different examples of capital structure:
Company A, for our purposes, has $150,000 in assets and $50,000 in liabilities. This means Company A's equity is $100,000.
The company's capital structure is therefore such that for every 50 cents of debt, the company makes $1 of equity.
This, then, would be an example of a low-leverage, or even low-risk, equity capital-structured company.
Now, take its cross-town rival, Company B. Company B has $120,000 in assets, $100,000 in debt and therefore $20,000 in equity.
Company B is "highly leveraged." For every $5 of debt, the company has $1 in equity. This means not only the company needs to increase its returns to be able to finance its debt, eventually, but the company also will be viewed as a greater risk to future lenders.