Designing of Capital Structure | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• Commencing a business necessitates a crucial consideration of capital, a primary funding source obtained through borrowing money or sharing equity. However, striking a balance between taking on excessive debt and diluting equity entirely poses challenges. To navigate this, organizations develop a capital structure design, offering a strategic framework on how capital should be raised—whether through debt or equity.
• The creation of a capital structure design is integral to meeting all financial obligations within an enterprise. This article delves into the essential steps and factors that must be taken into account before formulating the capital structure for a firm.

What is Capital Structure? 

• The composition of capital structure involves a blend of equity and debt, serving as a means to oversee business operations and facilitate organizational growth. The total capital of a company comprises two primary types: equity and debt capital. Equity capital is derived from the organization's shares, influencing its cash flows and earnings. On the other hand, debt is manifested through bond issues or loans, while equity finds representation in common stock, preferred shares, or net cash.
• Designing a company's capital structure is essential for effectively managing the capital base, seizing opportunities, mitigating risks, and fulfilling the business's requirements. The subsequent section explores certain practices employed by businesses in the design of their capital structure.

Importance of Designing Capital Structure

Finance stands as a pivotal resource for any business, and the effective management of it is entrusted to the capital structure. The significance of capital structure lies in its ability to optimize the market value of a firm and pique investor interest. Furthermore, it enhances a company's capacity to engage in future wealth-generating investments. Additionally, by determining an optimal blend of funding sources, the capital structure plays a role in diminishing the firm's cost of capital or cost of funds through financial leverage. Beyond these aspects, the capital structure encompasses various other crucial elements such as the expansion of investment opportunities.

Steps followed while Designing a Capital Structure

Developing an effective capital structure is crucial for a firm, and the following steps are typically taken in the process:

• Selecting Funding Sources: Firms need capital to meet performance demands, and while designing a capital structure, they assess various funding sources, weighing the pros and cons of equity and debt. This helps in understanding the financial, regulatory, and operational risks associated with each source.
• Reducing Capital Costs: Effective management strives to minimize capital costs. Companies with financial transparency attract investors offering capital at lower costs than competitors. Positive relationships with banks also contribute to securing favorable lending rates, enhancing overall profitability.
• Exploring Alternative Finance Sources: Forward-thinking firms continually seek non-traditional financing options, reducing reliance on conventional sources. This involves forming alliances, using assets as collateral, and implementing corporate structures to mitigate risks associated with market changes.
• Managing Flexible Capital: Companies adopting best practices actively balance debt-to-equity ratios, considering various factors influencing capital costs. Flexible financial policies, especially regarding dividends, allow the company to allocate funds as dividends while retaining the remainder for business growth.
• Aligning with Company Strategy: Top-tier companies design a capital structure that aligns with the company's strategy, providing flexibility to adapt to changing business environments. This approach focuses on organizational goals, operational excellence, and disciplined capital management tactics.
• Determining Financial Statements: Precise determination of the capital investment threshold requires awareness of the company's overall capital costs. Regularly measuring the Weighted Average Cost of Capital (WACC) is a common method to understand and track capital costs.
• Regularly Calculating WACC: Successful firms calculate WACC regularly using various methods to gain a comprehensive understanding of their financial standing. This approach aids in making informed strategic decisions within the industry and against competitors.

Conclusion

Capital stands as the paramount resource essential for industry operations, demanding a structured framework to sustain company activities. Companies secure funding from diverse sources, including debt with repayment obligations and equity requiring sharing, necessitating a well-defined structure. Crafting a capital structure involves various approaches such as choosing sources to fulfill capital needs, minimizing capital expenses, skillfully planning the capital foundation, among other methods. It is imperative to comprehend the concept of capital structure, its design, and the influencing factors due to its pivotal role in sustaining business operations.