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UNIT 17

Objectives

CAPITAL STRUCTURE

Capital Structure

The objectives of this unit are to: • • • explain the importance of decisions regarding capital structure identify the factors that have bearing on determining the capital structure explain the concept of an appropriate capital structure

Structure

17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 Introduction What is Capital Structure ? Features of an Appropriate Capital Structure Determinants of Capital Structure Summary Key Words Self-assessment Questions/Exercises Further Readings

17.1 INTRODUCTION

Finance is a important input for any type of business and is needed for working capital and for permanent investment. The total funds employed in a business are obtained from various sources. A part of the funds are brought in by the owners and the rest is borrowed from others-individuals and institutions. While some of the funds are permanently held in business, such as share capital and reserves (owned funds), some others are held for a long period such as long-term borrowings or debentures, and still some other funds are in the nature of short-term borrowings: The entire composition of these funds constitute the overall financial structure of the firm. You are aware that short-term funds keep on shifting quite often. As such the proportion of various sources for short-term funds cannot perhaps be rigidly laid down. The firm has to follow a flexible approach. A more definite policy is often laid down for the composition of long-term funds, known as capital structure. More significant aspects of the policy are the debt equity ratio and the dividend decision. The latter affects the building up of retained earnings which is an important component of longterm owned funds. Since the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision, the term financial structure is often used to mean the capital structure of the firm. There are certain sources of...