Corporate Finance

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Corporate Finance

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(Capital Structure and its importance)

SUBMITTED TO:
Prof: Muhammad Jameel

SUBMITTED BY:
M.Yasir Riaz

12165

Zubair Mehmood

12160

SUPERIOR UNIVERSITY
LAHORE

Acknowledgement
1

We at first bow our head before ALLAH
Almighty who bestowed his countless blessings upon us,
guided us towards the way of success, Bless us with
courage of facing problems and obstacles, Enabled us to
accomplish this work.
We find no words to say thanks to our Teacher Prof: Muhammad Jameel,
He is the one who enlightened our brains with
knowledge and who made
Us Capable of completing this
Project.

Table of Contents
2

Definition of Capital Structure.................................................................................... 4
Features of Capital Structure...................................................................................... 4
Components of Capital Structure................................................................................ 5
Importance of Capital Structure.................................................................................7
Difference between Capital Structure and Financial structure....................................9
Capital Structure Hierarchy...................................................................................... 11
Optimal Capital Structure with Examples.................................................................11
References................................................................................................................ 14

Definition of Capital Structure
3

Capital structure means the total of long-term debt, specific short-term debt, common equity and
preferred equity of an organization is known as capital structure. The capital structure is how a
firm finances its overall operations and growth by using different sources of funds. Debts are
generated from the banks and other lending institutions, where as the common and preferred
stock get through a process of issuing shares to share holders. The capital structure of a firm has
an essential role to check the financial position of that firm.

Features of Capital Structure
The features of capital structure of a company are as follows:
The term capital structure is used to represent the proportionate relationship between the various
long-term kinds of capital arrangements, equity, debentures, preference shares, long- term debt,
capital surplus, and retained earnings. The term capital structure is part of financial structure,
which includes both long-term and short-term funds. An appropriate capital structure should
incorporate the following features:
Feature
Flexibility

Detail
The term flexibility gives the finance manager the ability to alter the
firm’s capital structure with a minimum cost and delay, if warranted by the
changed environment. It should also be possible for the company to
provide funds whenever needed to finance its profitable activities.

Profitability

A strong capital structure should permit the high use of leverage at a
minimum cost so as to provide better profitability and then maximizing
earnings per share.

Solvency

The high debt threatens the solvency and credit rating of the company.
The debt financing should be only to that level which can be serviced fully
and also be paid back.

Conservatism

No company should exceed its debt capacity. As already explained that the
interest is to be paid on debt and the principal sum is also to be paid.
These payments depend on future cash flows. If future cash flows are not
sufficient then the cash insolvency can lead to legal insolvency.

Control

The capital structure should not lead to loss of control in the company.

4

Feature

Detail

Return

The capital structure of the company should
give maximum return to the shareholders.
Within the constraints, maximum use of the
leverage at a minimum cost should be made so
as to obtain maximum advantage of trading on
equity at minimum cost.

Risk

The capital structure should involve minimum
risk of financial insolvency. The use of
excessive debt threatens the solvency of the
company. Since use of debt ads to the risk of
the company and shareholders, it should be
used cautiously with equity.

Capacity

The company should have capacity to pay the
fixed periodic charges and the installments of
principal sum. The debt capacity of the
company should not be exceeded. The debt
capacity of a company depends on its ability to
generate cash flows.

Components of Capital Structure
The components of capital structure which form the capital structure as,
Stock is ownership
Preferred stock gets dividend before common stock and is preferred in the event of a liquidation
Debentures are unsecured debt
Loan stock pledges shares to secure loan

5

EQUITY CAPITAL
Invested money that, in contrast to debt capital, is not repaid to the investors in the
normal business. It represents the risk capital staked by the owners through purchase of
a company's common stock .
The value of equity capital is computed by estimating the current market value of everything
owned by the company from which the total of all liabilities is subtracted. On the balance
sheet of the company, equity capital is listed as stockholders' equity or owners' equity,
also called equity financing or share capital.
PREFERENCE SHARE CAPITAL
Investors have the opportunity to receive payment first but retain no shareholder privileges
RETAINED EARNINGS
Profits generated by a company that are not distributed to stockholders as dividends but are
either reinvested in the business or kept as a reserve for specific objectives (such as to pay off
a debt or purchase a capital asset).

6

A balance sheet figure shown under the heading retained earnings is the sum of all profits
retained since the company's inception. Retained earnings are reduced by losses, and are
also called accumulated
earnings,
accumulated
profit,
accumulated income,
accumulated surplus, earned surplus, undistributed earnings, or undivided profits. See
also retention ratio.

DEBENTURE
A promissory note or a corporate bond which is backed generally
the reputation and integrity of the borrower and by the borrower's specific assets.

only

by

TERM LOAN
Asset based short-term usually for one to five years loan payable in a fixed number of equal
installments over the term of the loan. Term loans are generally provided as working
capital for acquiring income producing assets like machinery, equipment, inventory that generate
the cash flows for repayment of the loan.
PUBLIC DEBT
Mortgages or other liabilities which a commercial entity is responsible to pay that back to the
lending institutions.

Importance of Capital Structure
The capital structure of a company has much importance not only for its financial position but
for its operations as well, here some factors which directly or indirectly influence capital
structure and these make its importance apparent.
Factors That Influence a Company's Capital Structure which explain the importance of Capital
Structure are as below,

FACTORE
Business Risk

Company's Tax Exposure

DETAIL
Excluding debt, business risk is the basic risk of the
company's operations. The greater the business risk,
the lower the optimal debt ratio.
Debt payments are tax deductible. As such, if a
company's tax rate is high using debt as a means of
7

Financial Flexibility

Management Style

Growth Rate

Market Conditions

Cash Flow Position

financing a project is attractive because the tax
deductibility of the debt payments protects some
income from taxes.
Financial flexibility is essentially the firm's ability to
raise capital in bad times. It should come as no
surprise that companies typically have no problem
raising capital when sales are growing and earnings
are strong.
Management styles range from aggressive to the
conservative. The more conservative a
management's approach is, the less inclined it is to
use debt to increase profits.
Firms that are in the growth stage of their cycle
typically finance that growth through debt by
borrowing money to grow faster.
Market conditions can have a significant impact on a
company's capital-structure condition. Suppose a
firm needs to borrow funds for a new plant.
While making a choice of the capital structure the
future cash flow position should be kept in mind.
Debt capital should be used only if the cash flow
position is really good because a lot of cash is
needed in order to make payment of interest and
refund of capital.

Return on Investment

The greater return on investment of a company
increases its capacity to utilize more debt capital.

Cost of Debt

The capacity of a company to take debt depends on
the cost of debt. In case the rate of interest on the
debt capital is less, more debt capital can be utilized
and vice versa.

Tax Rate

The rate of tax affects the cost of debt. If the rate of
tax is high, the cost of debt decreases. The reason is
the deduction of interest on the debt capital from the
profits considering it a part of expenses and a saving
in taxes, so the tax rate also effect on the capital
structure.

Cost of Equity Capital

Therefore, the use of the debt capital can be made
8

Regulatory Framework

Stock Market Conditions

Capital Structure of Other Companies

only to a limited level. If even after this level the
debt capital is used further, the cost of equity capital
starts increasing rapidly.
Capital structure is also influenced by government
regulations. For instance, banking companies can
raise funds by issuing share capital alone, not any
other kind of security.
Stock market conditions refer to upward or
downward trends in capital market. Both these
conditions have their influence on the selection of
sources of finance.
Capital structure is influenced by the industry to
which a company is related.

Difference between Capital Structure and Financial
structure
Here under some points which clearly differentiate the Capital Structure and Financial structure
are,
Meaning of Financial Structure
The specific mixture of long-term debt and equity that a company uses to finance its operations,
this financial structure is a mixture that directly affects the risk and value of the business. The
main concern for the financial manager of the company is deciding how much money should be
borrowed and the best mixture of debt and equity to obtain. The financial manager also has to
find the least expensive sources of funds for the company to use.
Meaning of Capital Structure
Capital structure is the mixture of long term capital and debt resources. Check your balance sheet
and you will find that there will be 3 main sources of capital. One is equity share, second is pref.
share and third is debenture. Fund from these sources are collected and used for buying the long
term and short term assets. If more briefly, we have to define the capital structure, we can say
that total fund is financed from share capital and debt.
Basis of Capital Structure
Financial Structure is the base of capital structure. Whole capital structure is the part of financial
structure.
9

Basis of Financial Structure
There are lots of basis of financial structure. We can also say the factor which affects the
financial structure. Nature of business, type of business, investment requirement, long term and
working capital requirement, cost of capital, cash flow ability of company and leverage are its
main factor which affects it.

EXAMPLES:

Example of Capital Structure

Long term debt =$ 30,000
Equity Share Capital = $ 70,000
Proffered Share Capital = $ 10,000
Retained Earning = 5000
--------------------------------------------Total Long term Fund = $ 115000
---------------------------------------------

Example of Financial

Long Term Liabilities = $ 115000
Current Liability = $ 85000
--------------------------------------------Total Liabilities = $ 200000
---------------------------------------------

10

Capital Structure Hierarchy

CAPITAL STRUCTURE

DEBTS

EQUITY

BANK LOAN

PREFERRED EQUITY

CONVERTIBLE BOND

COMMON EQUITY

HIGH YEILD DEBTS

RETAINED EARNING
RIGHT SHARE

11

Optimal Capital Structure with Examples
Definition of Optimal Capital Structure
The best debt to equity ratio for a firm that maximizes its value, the optimal capital structure for
a company is one which offers a balance between the ideal debts to equity ranges and minimizes
the firm's cost of capital.
OR
A company's ratio of short and long term debt should also be considered when examining its
capital structure. Capital structure is most often referred to as a firm's debt to equity ratio, which
provides insight into how risky a company is for potential investors. Determining an optimal
capital is a chief requirement of any firm's corporate finance department.

Estimating the Optimal Capital Structure
There are numerous ways in which a company’s optimal capital structure can be estimated. the
most commonly used ones are:
Method 1
One method of estimating a company’s optimal capital structure is utilizing the average or
median capital structure of the principle companies engaged in the market approach. This
approach is helpful as the appraiser is well aware about which companies are included in the
analysis and the degree to which they are related to the subject company
Method 2
This method is applied if the risk of a company did not change because of the nature of its capital
structure, and a company would wish as much debt as possible, as the interest payments are tax
deductible and debt financing is always cheaper than equity financing. The main objective of this
method is determining the debt level at which the benefits of increased debt does not overshadow
the increased risks and potential costs associated with a economically distressed company.

EXAMPLE

12

Optimal Capital Structure: A best debt/equity ratio for a company. This is the long-term-debt
to equity ratio that will minimize the cost of capital.
Debt Equity Ratio indicates what proportion of equity and debt the company is using to finance
its assets.

A, XYZ company has want to calculates its debts equity ratio and the data for it is as below its
Debts,

Short term debts = 500,000
Long term debts = 10,000,000
Total Debts = 15,000,000
And the equity is,

Common Equity = 5000,000
Preferred Equity = 250,000
Additional or fresh capital = 600,000
Retained Earnings = 3,250,000
Total Equity = 10,000,000

= 15,000,000/ 10,000,000
=1.5%
This shows the debts equity ratio is favorable because the debts financing is higher than equity
and that is cheaper so the capital structure is optimal.

13

References
A Book, FINANCIAL MANAGEMENT (6th edition) by M.Y.Khan and P.k.Jain, (page 19.1 to 19.8)
http://econpapers.repec.org/article/eeejbfina/v_3a35_3ay_3a2011_3ai_3a2_3ap_3a3
58-371.htm
http://en.wikipedia.org/wiki/Capital_structure
http://www.managebuddy.com/notes/financial-management/features-of-anappropriate-capital-structure/
http://www.investopedia.com/terms/c/capitalstructure.asp
http://www.linkedin.com/groups/importance-capital-structure-in-creating4092220.S.133746203
http://campus.murraystate.edu/academic/faculty/lguin/FIN330/Optimal%20Capital
%20Structure.htm
http://www.svtuition.org/2013/06/capital-structure-vs-financial-structure.html

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