CAPITAL STRUCTURE FOR FIRMS

CAPITAL STRUCTURE FOR FIRMS - DEVELOPING AN OPTIMAL CAPITAL...

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DEVELOPING AN OPTIMAL CAPITAL STRUCTURE FOR FIRMS. Definition: Capital structure is the mix of debt and equity that a firm uses to finance its operations. The financing or capital structure decision is a significant managerial decision. It influences the shareholders return and risk. Consequently the market value of the shares may be affected by the capital structure decision. The Various means of financing represents the financial structure of an enterprise. Traditionally, short- term borrowing are excluded from the list of methods of financing the firm’s capital expenditure, and therefore , the long term claims are said to form the capital structure of an enterprise. Therefore capital structure represents the relationship between equity and debt. Equity includes paid-up share capital, share premium and reserves and retained earnings Capital structure decision process The assets of a company can be financed either by increasing the owner claims or the creditor claims. The owner claims increase when the firm raises funds by issuing ordinary shares or by retaining the earnings;the creditors claims increase by borrowing. The various means of financing represent the financial structure of an enterprise.
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The process of the capital structure decision is shown in the figure above. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. The decision will involve an analysis of the existing capital structure and the factors which will govern the decision at present. The company’s policy to retain or distribute earnings affects the owners claims. Shareholder equity position is strengthened by retention of earnings. Thus, the dividend decision has a bearing on the capital structure of the company. The new financing decision of the company may affect its debt-equity mix. Factors That Affect Capital Structure 1. Availability of securities – This influences the company’s use of debt finance which means that if a company has sufficient securities, it can afford to use debt finance in large capacities. 2. Cost of finance (both implicit and explicit) – If low, then a company can use more of debt or equity finance. 3. Company gearing level – if high, the company may not be able to use more debt or equity finance because potential investors would not be willing to invest in such a company. 4. Sales stability – If a company has stable sales and thus profits, it can afford to use various finances in particular debt in so far as it can service such finances. 5. Competitiveness of the industry in which the company operates – If the company operates in a highly competitive industry, it may be risky to use high levels of debt because chances of servicing this debt may be low and may lead a company into receivership.
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