Financial Management

Semester : I

Subject : Financial Management

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Q.2: Explain the factors determining Capital Structure.

In finance, Capital Structure refers to the way a corporation finances its assets through some combination of equity, debt or hybrid securities. In other words, Capital Structure is how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

The Capital Structure decision is a significant managerial decision which influences the risk and return of the investors. Wherever the company wants to raise finance, it involves a capital structure decision. Both the amount of finance to be raised as well as the source from which it is to be raised have to be decided by the management.

Following important factors are to be considered while determining the capital structure.

1) Financial Leverage - A financial manager must examine in detail how the Use of proposed financing mix will affect the risk and return of the owners. The financial leverage employed by the company will depend on the amount of risk the company would like to take.

The use of debt & preference share capital in the capital structure increases the equity shareholders’ return because:

• The rate of return on investment is more than the rate of interest on debt and rate of dividend on preference capital and hence the difference is distributed to shareholders.

• The interest paid on debt is tax deductible and hence there is a tax saving.

The disadvantages of using debt in the capital structure are:

• There is financial risk involved as interest on debt (being a charge against...