Capital Structure Importance, Factors, Features, Determinants

Table of Contents:-

  • Capital Structure Theories
  • Factors Affecting Capital Structure
  • Importance of Capital Structure
  • What is Capital Structure
  • Characteristics of Capital Structure
  • Features of Capital Structure
  • Determinants of Capital Structure
  • Factors Determining Capital Structure

Capital Structure Theories

A firm should aim to maintain an optimum capital structure to ensure financial stability. The optimum capital structure is achieved when the market value per equity share is at its maximum. To identify the optimum debt-equity mix, the finance manager needs to be familiar with the fundamental theories underlying the capital structure of corporate enterprise.

  1. NI Approach
  2. NOI Approach
  3. MM Approach
  4. Traditional Approach

Common assumptions of the theories of capital structure decision are as follows:

(i) Preference share capital is merged with debt. The company uses only debt and equity capital.

(ii) There are no corporate taxes.

(iii) EBIT is not expected to grow.

(iv) The firm’s total financing remains constant.

(v) The business risk does not change with the growth of the business firm.

(vi) All investors have the same subjective probability distribution of the future expected earnings for a given firm.

Net Income (NI) Theory

According to this approach, the capital structure decision is relevant to the valuation of the firm inasmuch as a change in the pattern of capitalization brings about a corresponding difference in the overall cost of capital and the total value of the firm. This theory, also known as the fixed-ke theory, was propounded by David Durand. The critical assumptions of this theory are:

(i) There are no corporate taxes.

(ii) The debt content does not change investors’ risk perception.

(iii) The cost of debt is lower than the cost of equity.

The theory operates on the belief that – “As the proportion of more affordable debt funds in the capital structure increases, the weighted average cost of capital decreases and approaches the cost of debt.”

This theory recommends that 100% debt financing is the optimal capital structure. The following are the strengths of the NOI approach:

(i) It tries to explain the effects of borrowings on the overall cost of capital.

(ii) It explains and emphasizes favourable financial leverage.

(iii) However, the theory ignores risk considerations.

Net Operating Income (NoI) Approach

This approach, also propounded by Durand, is just the opposite of the Net Income (NI) approach. According to this approach, the overall cost of capital and the value of the firm are independent of capital structure decisions, and a change in the degree of financial leverage does not bring about any change in the value of the firm and the cost of capital.

The approach is based on the following assumptions:

(i) The overall cost of capital (ko) remains constant for all degrees of debt-equity mix or leverage.

(ii) There are no corporate taxes.

(iii) The market capitalizes the value of the firm as a whole.

(iv) The advantage of debt is offset precisely by an increase in the equity capitalization rate.

According to the NOI Approach, the value of a firm can be determined by the equation given below:

v = EBIT/Ko


V = Value of firm;
K = Overall cost of capital
EBIT = Earnings before interest and tax.

Thus, according to the Net Operating Income (NOI) Approach, any capital structure will be optimum.

The following are the strengths of the NOI approach:

(i) It emphasizes the role of NOI in the determination of the total value of the firm.

(ii) According to this theory, new investment proposals should be based on the NOI approach.

However, this theory ignores the behavioural aspect of the financing function of management.

Modigilian – Miller (MM) Theory

The Modigliani-Miller (MM) theory is similar to the Net Operating Income (NOI) theory. It supports the NOI approach by providing behavioural justification for the independence of the total valuation and the cost of capital of the firm from its capital structure. In other words, the MM approach maintains that the weighted average price of money does not change with a change in the capital structure of the firm.

The following are the three basic propositions of the MM theory:

(i) The overall cost of capital (Ko) and the value of the company (V) are independent of the capital structure.

(ii) The cost of equity (KE) is equal to the capitalization rate of a pure equity stream plus a premium for financial risk.

(iii) The cut-off rate for investment purposes is entirely independent of the method used to finance the investment.

Assumptions of Modigliani-Miller (MM) Theory

The MM theory is subject to the following assumptions:

1. Capital markets are perfect.

2. All firms within the same class will have the same degree of business risk.

3. All investors have the same expectation of a company’s net operating income (EBIT).

4. The dividend payout ratio is 100%.

5. There are no corporate taxes.

However, this assumption was later removed.

The “arbitrage process” is the operational justification for the MM hypothesis. The term ‘Arbitrage’ refers to the act of buying an asset or security in one market at a lower price and selling it in another market at a higher price. The consequence of such action is that the market price of securities of two firms, exactly similar in all respects except in their capital structures, cannot remain different for long in other markets. Thus, the arbitrage process restores equilibrium in the value of securities. This is because if the market value of two equal firms differs, an overvalued firm would sell its shares, borrow additional funds on a personal account, and invest in the undervalued firm to obtain the same return on a smaller investment outlay. The investor’s utilization of debt for arbitrage is called ‘home-made’ or ‘personal leverage.’

Limitations of Modigliani-Miller (MM) Theory

The following are the limitations of MM’s theory:

(i) Rates of interest differ for individuals and firms.

(ii) Transactional costs are involved.

(iii) Home-made leverage is a better substitute for corporate leverage.

(iv) The effectiveness of the arbitrage process is limited.

Since corporate taxes do exist, MM agreed in 1963 that the value of the firm would increase, and the overall cost of capital would decline because  of the tax deductibility of interest payments. A levered firm should, therefore, have a greater market value compared to an unleveled firm. The value of the levered firm would exceed that of the unleveled firm by an amount equal to the levered firm’s debt multiplied by the tax rate. The formula is –

Vi = Vu + Bt

Where :

Vi = Value of levered firm
Vu = Value of an unlevered firm
B = Amount of Debt and
t = Tax rate

Traditional Approach

The traditional theory assumes changes in Ke at different levels of the debt-equity rate. It is in the middle of the two extremes of NI and NOI. Beyond a particular point of the debt-equity mix, Ke rises at an increasing rate. There are three stages:

I Stage – Introduction of debt: Net Income rises; the cost of equity capital increases because of risk but less than the earnings rate, leading to a decline in the overall cost of capital and a growth in market value.

II Stage – Further application of debt: The cost of equity capital rises, net income – debt cost increases – value remains the same.

III Stage – Further application of debt: The cost of equity capital is very high – value goes down.

Factors Affecting Capital Structure

The following are the major factors that should be kept in view while determining the capital structure of a company:

    1. Size of Business
    2. Form of Business Organization
    3. Nature of Enterprise
    4. Stability of Earnings
    5. Age of Company
    6. Purpose of Financing
    7. Market Sentiments
    8. Credit Standing
    9. Period of Finance
    10. Tax Considerations

Size of Business

Smaller firms confront tremendous problems in assembling funds due to their poor creditworthiness. Investors are reluctant to invest their money in securities of these firms, and lenders impose highly restrictive terms on lending. In view of this, special attention should be paid to the maneuverability principle. This is why common stock represents a major portion of the capital in smaller concerns. Larger concerns have to employ different types of securities to procure the desired amount of funds at a reasonable cost because they find it challenging to raise capital at a reasonable cost when the demand for funds is restricted to a single source.

Form of Business Organization

The control principle should be given higher weightage in private limited companies where ownership is closely held in a few hands. This may be less imminent for public limited companies with numerous shareholders. In the proprietorship or partnership form of organization, control is undoubtedly an important consideration because control is concentrated in a proprietor or a few partners.

Nature of Enterprise

Business enterprises that have stability in their earnings or enjoy a monopoly regarding their products may go for debentures or preference shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend. This is true in the case of public utility concerns. On the other hand, companies that do not have this advantage should rely on equity share capital to a greater extent for raising their funds. This is particularly true in the case of manufacturing enterprises.

Stability of Earnings

With greater stability in sales and earnings, a company can insist on fixed-obligation debt with less risk. However, a company with irregular income will choose to avoid burdening itself with fixed charges. Such a company should depend upon the sale of stock to raise capital.

Age of Company

Younger companies generally find it difficult to raise capital in the initial years because of the greater uncertainty involved and the need for recognition from fund suppliers. Therefore, it would be worthwhile for such companies to give higher weightage to the manoeuvrability factor. In contrast, established companies with a good earnings record are always in a comfortable position to raise capital from various sources. The leverage principle should be insisted upon in such concerns.

Purpose of Financing

If funds are required for directly productive purposes, the company can afford to raise funds by issuing debentures. On the other hand, if the funds are needed for non-productive purposes, such as providing more welfare facilities to employees, the company should raise funds by issuing equity shares.

Market Sentiments

During times of economic boom, investors generally seek absolute safety. In such cases, it is appropriate to raise funds by issuing debentures. During other periods, when people are interested in earning high speculative incomes, it is fair to raise funds by issuing equity shares.

Credit Standing

A company with a high credit standing has a greater ability to adjust sources of funds upwards or downwards in response to major changes in the need for funds than one with poor credit standing. In the former case, the management should pay greater attention to the manoeuvrability factor.

Period of Finance

The period for which finance is required also affects the determination of the capital structure of companies. In case funds are needed, say, for 5 to 10 years, it will be appropriate to raise them by the issue of debentures. However, if the funds are required more or less permanently, it will be applicable to raise them by the issue of equity shares.

Tax Considerations

Existing taxation provisions make debt more advantageous than stock capital, as interest on bonds is a tax-deductible expense, whereas dividends are subject to tax. Considering the prevailing corporate tax rates in India, the management may prefer to increase the degree of financial leverage by relying more on borrowing.

Importance of Capital Structure

Finance is an essential input for any business, necessary for working capital and permanent investments. The total funds employed in an industry are sourced from various channels. The owners contribute a portion of the funds, while the remainder is borrowed from individuals and institutions. Some funds are permanently held in the business, such as share capital and reserves (owned funds), while others are for a long period, like long-term borrowings or debentures. Additionally, certain funds are in the form of short-term borrowings. The overall composition of these funds constitutes the firm’s financial structure.

Short-term funds often shift frequently, making it challenging to define the proportion of various sources for short-term funds rigidly. Hence, a flexible approach is necessary. In contrast, a more definite policy is typically established for the composition of long-term funds, known as the capital structure. Key aspects of this policy include:

  • The debt-equity ratio and the dividend decision.
  • Influencing the accumulation of retained earnings.
  • A crucial component of long-term owned funds.

Since permanent or long-term funds often represent a substantial portion of total funds and involve long-term policy decisions, the term “financial structure” is often used interchangeably with the capital structure of the firm.

Corporate enterprises generally have access to specific sources of long-term funds. The primary sources include share capital (owners’ funds) and long-term debt, including debentures (creditors’ funds). Profits earned from operations constitute owners’ funds, which can be either retained in the business or distributed to shareholders as dividends. The portion of profits retained in the company serves as a reinvestment of owners’ funds and is, therefore, another source of long-term funds. Together, these sources form the primary constituents of the business’s capital, constituting its capital structure.

What is Capital Structure

The term `capital structure’ represents the total long-term investment in a business company. It includes funds raised through ordinary and preference shares, debentures, bonds, term loans from financial institutions, etc. Any capital ‘ surpluses and earned revenue are included.

Capital Structure Planning

The decision regarding the type of capital structure a company should adopt is of critical importance due to its potential impact on profitability and solvency. Small companies often neglect planning their capital structure, allowing it to develop without formal consideration. While these companies may perform well in the short run, they eventually face significant difficulties. The unplanned capital structure hinders the economical use of funds for the company. Therefore, a company should proactively plan its capital structure to maximize advantages and easily adapt to changing conditions.

Rather than employing a scientific approach to determine an appropriate proportion of different types of capital that minimizes the cost of capital and maximizes market value, some companies may choose to follow the capital structures of comparable companies or seek advice from institutional lenders.

In theory, a company should aim for an optimum capital structure that maximizes the market value of its shares. This value is achieved when the marginal real cost of each source of funds is equal. However, the practical determination of an optimum capital structure is a challenging task, often requiring consideration beyond theoretical frameworks. This complexity leads to significant variations in capital structures among industries and even within the same industry.

Various factors influence a company’s capital structure decision, and the judgement of the individuals making these decisions is crucial. Two similar companies may have different capital structures if decision-makers have differing opinions on the significance of various factors. These factors are often psychological, complex, and qualitative, deviating from accepted theories. Capital markets are imperfect, and decisions must be made with inadequate knowledge and associated risks. If you’re interested in identifying important factors influencing capital structure planning in practice, this imperfect knowledge becomes particularly relevant.

Characteristics of Capital Structure

The capital structure is typically planned with a focus on the interests of ordinary shareholders, who are the ultimate owners of the company and possess the right to elect directors. When developing an appropriate capital structure for their company, financial managers should aim to maximize the long-term market price of equity shares.

In practical terms, most companies within an industry will have a range of suitable capital structures, and the market values of shares within this range will remain the same. Determining an empirical capital structure is possible in such cases. For instance, a company in an industry with an average debt-to-total-capital ratio of 60% might find, through empirical analysis, that shareholders generally accept the company operating within a 15% range of the industry’s intermediate capital structure.

As a result, the appropriate capital structure for the company may fall between a 45% to 75% debt-to-total-capital ratio. The company’s management should position the capital structure near the upper end of this range to maximize the advantageous use of leverage, considering other factors such as flexibility and solvency requirements.

Features of Capital Structure

Every company aims to establish an appropriate capital structure, striving to achieve a debt-equity proportion that maximizes the market value of shares and minimizes the cost of capital. The features of a sound and appropriate capital structure include:

1. Profitability

The company’s capital structure should be highly advantageous within given constraints. It should maximize the use of leverage at a minimal cost. A sound capital structure enables the most effective utilization of leverage at the lowest possible cost, enhancing performance and thereby maximizing earnings per share.

2. Solvency

Excessive use of debt poses a threat to the company’s solvency. Therefore, debt should be employed judiciously to maintain financial stability. Excessive debt jeopardizes the company’s solvency and credit scores. Debt financing should be limited to an extent that allows for proper repayment.

3. Flexibility

The capital structure needs to be flexible to adapt to changing conditions. The company should be capable of adjusting its capital structure with minimal cost and delay in response to altered situations. Additionally, it should have the ability to provide funds promptly when necessary to finance profitable activities. A financial manager should be capable of modifying the firm’s capital structure with minimal expense when necessary. Therefore, the company needs to provide funding to support its productive operations.

4. Control

The capital structure should remain the same to the extent that it results in a loss of power within the company. The proportions of debt and equity should be maintained in a way that ensures there is no loss of control.

5. Conservatism

A company should always stay within its debt capacity to the extent that servicing the debt becomes challenging. The interest and principal balances must be fulfilled as per the debt obligations. It is anticipated that future cash flows will facilitate these payments. Cash insolvency can escalate to legal insolvency if potential cash flows prove insufficient.

From a solvency perspective, capital structuring should be approached with careful consideration. The company’s debt capacity, which relies on its ability to generate future cash flows, should not be surpassed. Sufficient cash reserves should be maintained to meet periodic fixed charges to creditors and repay the principal sum on maturity.

These are general features of an appropriate capital structure, and specific characteristics may vary based on the company. Furthermore, the emphasis placed on each part may differ among companies. For instance, one company might prioritize flexibility over control, while another might be more concerned with solvency than other requirements. Additionally, the relative importance of these features may change in response to evolving conditions.

Determinants of Capital Structure

The capital structure needs to be determined when a company is established, and the initial design requires careful consideration. The management should set a target capital structure, and subsequent financing decisions should align with achieving this target. As a company matures and operates over the years, the financial manager must then contend with the existing capital structure.

When the company requires continuous funds to finance its activities, the financial manager evaluates various sources of finance each time funds need to be procured. The manager selects the most advantageous sources with the target capital structure in mind. Consequently, the capital structure decision becomes an ongoing process, requiring attention whenever additional finance is needed.

Common factors considered when making a capital structure decision include:

  1. Leverage or trading on equity,
  2. Cost of capital,
  3. Cash flow,
  4. Control,
  5. Flexibility,
  6. Size of the company,
  7. Marketability, and
  8. Floatation costs.

Let’s briefly understand these factors.

Leverage or Trading on Equity

The utilization of fixed-cost sources of finance, such as debt and preference share capital, to fund a company’s assets is termed financial leverage or trading on equity. When assets financed by debt generate a return greater than the cost of the debt, earnings per share can increase without an additional investment from the owners. Similarly, using preference share capital to acquire assets can also increase earnings per share. However, the impact of leverage is more pronounced with debt for two main reasons:

(i) the cost of debt is typically lower than the cost of preference share capital, and

(ii) the interest paid on debt is a deductible charge from profits when calculating taxable income, whereas dividends on preference shares are not.

Due to its impact on earnings per share, financial leverage is crucial when planning a company’s capital structure. Companies with high Earnings Before Interest and Taxes (EBIT) can effectively utilize significant force to enhance shareholders’ equity returns. An established method for assessing the influence of leverage is to analyze the relationship between Earnings Per Share (EPS) at various potential levels of EBIT, considering alternative financing methods. EBIT-EPS analysis is a valuable tool for financial managers, providing insights into managing a firm’s capital structure. Managers can evaluate the potential fluctuations in EBIT and assess their effects on EPS across different financing plans.

Cost of Capital

Measuring the costs of various sources of funds is a complex subject that requires separate treatment. Undoubtedly, it is desirable to minimize the cost of capital. Therefore, cheaper sources should be preferred, assuming all other factors remain the same.

The cost of a source of finance represents the minimum return expected by its suppliers. This expected return is contingent upon the degree of risk investors assume, with shareholders carrying a higher risk level than debt holders. The interest rate is fixed for debt holders, and the company is legally obligated to pay interest, regardless of its profitability. The dividend rate is not set for shareholders, and the Board of Directors has no legal obligation to distribute dividends, even if the company has generated profits.

Debt-holders receive the repayment of their loan within a specified period, whereas shareholders can only recover their capital when the company is liquidated. This leads to the conclusion that debt is a more cost-effective source of funds than equity. Additionally, the tax deductibility of interest charges further reduces the cost of debt. While preference share capital is cheaper than equity capital, debt is more cost-effective.

Striking the Balance: Optimizing Debt and Equity in Capital Structure for Cost-Efficiency

To minimize the overall cost of capital, a company should leverage a substantial debt.

However, it should be recognized that a company cannot continually minimize its overall cost of capital by relying solely on debt. There is a threshold beyond which debt becomes more expensive due to the heightened risk posed to both creditors and shareholders. As the degree of leverage increases, so does the threat to creditors, potentially leading them to demand a higher interest rate or even refuse to provide additional loans once a specific debt level is reached.

Moreover, excessive debt introduces significant risk to shareholders, consequently elevating the cost of equity. While up to a certain point, the overall cost of capital decreases with the use of debt, the cost of money rises beyond that threshold. Consequently, it becomes disadvantageous to employ debt further. Therefore, finding the right combination of debt and equity is essential to minimize the firm’s average cost of capital and maximize the market value per share.

The cost of equity encompasses both the cost of issuing new shares and the cost associated with retained earnings. Notably, the debt cost is more economical than both equity sources. The latter is the more cost-effective option when considering the cost between new share issues and retained earnings.

Optimal Funding Sources: Analyzing the Cost Benefits of Retained Earnings, Debt, and Equity in Capital Structure Management

Retained earnings incur lower costs than new share issues for two main reasons. Firstly, the company is exempt from paying personal taxes that shareholders must pay on distributed profits. Secondly, unlike new share issues, no flotation costs are incurred when earnings are retained. Consequently, retained earnings are considered the more preferable and cost-efficient choice between these two sources.

Thus, it seems reasonable for a firm to utilize a substantial amount of debt when considering factors such as leverage and the cost of capital, provided its earnings do not fluctuate widely. Debt can be employed to the extent where the average cost of capital is minimized. The interplay of these two factors establishes the upper limit for using debt. However, other considerations must also be assessed to determine the appropriate capital structure for a company.

Theoretically, a company should strive for a balance of debt and equity that results in the lowest possible overall cost of capital.

Cash Flow

One characteristic of a sound capital structure is conservatism, which does not necessarily imply the absence of debt or a minimal amount of debt. Conservatism is associated with evaluating the liability for fixed charges resulting from using debt or preference capital in the capital structure, considering the firm’s ability to generate cash to fulfil these fixed obligations.

The fixed charges of a company encompass interest payments, preference dividends, and principal repayment. Fixed costs increase when a company utilizes a substantial debt or preferred capital. When contemplating additional debt, a company should analyze its anticipated future cash flows to ensure it can meet these fixed charges. It is imperative to pay interest and return the principal amount of debt, and failure to generate sufficient cash to meet these obligations could lead to financial insolvency.

Companies anticipating significant and stable cash inflows can comfortably incorporate substantial debt into their capital structure. However, it is somewhat risky for companies with unpredictable or unstable cash inflows to rely on sources of capital with fixed charges.


In designing the capital structure, the existing management is sometimes motivated to maintain control over the company. The current management team may want to secure election to the Board of Directors and seek to manage the company without external interference.

Ordinary shareholders possess the legal right to elect the company’s directors. However, when the company issues new shares, there is a risk of losing control, which is less significant for widely held companies. In such cases, claims are widely dispersed, and most shareholders must actively participate in the company’s management. They are primarily interested in dividends and share price appreciation. Distributing shares widely and in small lots is an effective strategy to mitigate the risk of loss of control.

Maintaining control becomes a more critical issue for closely held companies. A shareholder or group could acquire a significant portion of the new shares, thereby gaining company control. The fear of sharing power and potential interference from others often leads closely held companies to hesitate before going public. Companies may issue preference shares or raise debt capital to counter the risk of losing control.

While using debt to avoid the loss of control is a common suggestion, it’s essential to note that substantial debt comes with restrictions imposed by debt-holders to safeguard their interests. These restrictions limit the management’s freedom to operate the business. Excessive debt may also lead to bankruptcy, resulting in a complete loss of control.


Flexibility refers to a firm’s capacity to adjust its capital structure in response to changing conditions. A company’s capital structure is considered flexible when it can easily modify its capitalization or sources of funds. The company should have the ability to raise funds promptly and cost-effectively whenever necessary to finance profitable investments. Additionally, the company should be able to redeem its preference capital or debt as dictated by future conditions. The financial plan of the company must exhibit flexibility, allowing for adjustments to the composition of the capital structure. It should position itself to substitute one form of financing for another, aiming to optimize the utilization of funds.

Size of the Company

The size of a company significantly influences its access to funds from various sources. Small companies often face challenges in securing long-term loans, and if they manage to obtain one, it comes with high interest rates and inconvenient terms. The stringent covenants in loan agreements for small companies contribute to an inflexible capital structure, limiting management’s operational freedom. Consequently, small companies often rely on owned capital and retained earnings for their long-term funds.

In contrast, large companies enjoy greater flexibility in shaping their capital structure. They can secure loans on favorable terms and also issue ordinary shares, preference shares, and debentures to the public. A company should leverage its size advantage when planning its capital structure to make optimal financial decisions.


Marketability, in this context, refers to the company’s ability to sell or market a particular type of security within a specific timeframe, contingent on the willingness of investors to purchase that security. While marketability may not significantly impact the initial capital structure, it is crucial in determining the suitable timing for security issuances.

Due to changing market sentiments, the market’s preference for debenture or ordinary share issues fluctuates over time. Consequently, the company must decide whether to raise funds through common shares or debt based on prevailing market conditions. If the share market is depressed, the company should refrain from issuing ordinary shares and opt for debt issuance instead. It can wait to issue ordinary shares until the share market experiences a revival. Conversely, successfully issuing debentures may be challenging during a boom period in the share market. In such cases, the company should keep its debt capacity unutilized and issue ordinary shares to raise finances.

Floatation Costs

Floatation costs are incurred when funds are raised. Generally, the cost of floating a debt is lower than floating an equity issue. This may incentivize a company to opt for debt rather than issuing ordinary shares. No floatation costs are incurred when the owner’s capital is increased by retaining earnings. Generally, floatation costs are not a highly influential factor in determining a company’s capital structure, except in the case of small companies.

Factors Determining Capital Structure

Capital structure is influenced by various factors, both internal and external to the organization. The key factors affecting capital structure include:

1) Nature and Size of Business

The scale of a company strongly determines its capital structure. Trading companies, requiring substantial operating capital, typically raise funds through the issuance of equity and preference shares. Small businesses, constrained in collecting capital from external investors, often rely on owner’s funds. In contrast, larger firms, with more financial resources, may issue debentures backed by fixed assets like property and buildings. The perception of risk also differs for investors between small and large businesses.

2) Stages of Business

In the early stages, companies may face challenges in obtaining financing through various securities due to high risks. Consequently, relying on equity shares for capital is advisable. As the business matures, other forms of shares and interest-bearing debentures can be issued for expansion or modernization. Companies with volatile profits are cautioned against using leverage, as unpredictable cash flow may impede meeting fixed interest payments.

3) Management’s Desire for Control

Management preferences impact capital structure. If management seeks full control, they may raise funds through preference shares and debt, as holders of these shares lack voting powers and cannot influence executive decisions.

4) Taxation

Dividends are not tax-deductible expenses for companies, while interest on debt is. Therefore, issuing debt capital is favored over share capital, especially for businesses with higher tax liabilities.

5) Period of Funding

The duration for which funding is required plays a role in determining capital structure. If funds are needed consistently, issuing equity shares is a viable option. For shorter-term financing needs, debentures or preference shares may be issued.

In summary, capital structure decisions are multifaceted and depend on the specific circumstances, size, stage, and goals of the business, as well as managerial preferences and tax considerations.


Capital structure refers to the composition of various sources of long-term finance in the total capitalization of a company, with ownership and creditors’ securities being the two primary sources. Most large industrial companies utilize both types of securities and long-term loans from financial institutions.

Effective capital structure planning is crucial for a company’s profitability, initially and continuously. A wrong initial decision can be costly for the company.

When making decisions about capital structure, careful attention should be given to profitability, solvency, and flexibility objectives. The choice between debt and other fixed-return securities and variable-income securities, like equity shares, is made after thoroughly comparing each type’s characteristics and a thoughtful consideration of internal and external factors related to the firm’s operations.

In real-life situations, compromises are inevitable between the expectations of companies seeking funds and those supplying them. However, these compromises maintain the fundamental distinctions between debt and equity. Generally, the decision about financing is not a choice between equity and debt but involves selecting the ideal combination of the two. Considerations of suitability, risk, income, control, and timing influence the decision on the debt-equity mix. The weights assigned to these factors will vary from company to company, depending on the industry’s characteristics and the company’s specific situation.

There may be an approximate mathematical solution to the decision on capital structuring. Human judgment is crucial in analyzing conflicting forces before deciding on the appropriate capital structure.


1. What is Capital Structure?

Capital structure, or financial structure, refers to the blend of various types of long-term sources of funds, namely debentures, bonds, loans from financial institutions, preference shares, and equity shares (including retained earnings).

2. What is capital structure in financial management?

Capital Structure refers to the mixture of owned and borrowed capital. It encompasses the share of debt, preference, and equity capital in the financing of a firm’s assets. The primary goal of financial management is to enhance the value of the equity shares of the firm, i.e., to maximize the wealth of the equity shareholders. Consequently, a firm is required to choose a financing mix that results in boosting the wealth of equity shareholders.

A capital structure that maximizes the value of equity shareholders and minimizes the cost of capital is referred to as an optimum capital structure. The value of a firm is dependent upon the earnings of the firm and its weighted average cost of capital. The firm’s value is derived by capitalizing the earnings by its cost of capital. The optimal capital structure is the combination of debt and equity that maximizes the total value of the firm or minimizes the overall cost of capital.

Capital structure is defined as the allocation of capital through various long-term funding sources, divided into two categories: equity and debt. Corporations may collect funds through equity shares, preference shares, retained profits, long-term debt, and other forms of funding, which are then used to sustain the company.


3. what is optimal capital structure?

An optimal capital structure achieves the best balance between debt and equity financing, maximizing the market value of the company while minimizing its cost of capital. A company aims to minimize its weighted average cost of money to acquire funds at the lowest price. However, some economists argue that if there are no taxes, agency costs, and efficient flow of information, then the value of the firm will not be influenced by its capital structure. Nevertheless, in the real world, taxes, agency costs, and asymmetric information exist. Therefore, it is essential to establish an optimal capital structure that minimizes the overall cost. However, determining a specific mix of debt and equity and labelling it as optimal can be challenging.

4. Theories of capital structure in financial management

There are several contending capital structure theories, with some theories asserting that capital structure decisions are crucial as they impact the value of the firm, making capital structure relevant. On the other hand, some theories argue that capital structure is irrelevant as it does not affect the value of the firm. Some of the capital structure theories include:

1) Net Income Approach
2) Net Operating Income Approach
3) Modigliani-Miller (MM) Approach
4) Traditional Approach

All these capital structure theories are based on certain assumptions:

  1. There are only two types of funding available: debt and equity. Other forms of financing, such as preference share capital and retained earnings, do not exist.
  2. The firm will pay all its earnings as dividends, resulting in a dividend payout ratio of  1.
  3. There are no costs of floatation and no transaction costs.
  4. The firm has a perpetual life.
  5. All investors are rational, aiming to maximize their return while minimizing risk.
  6. Both the cost of debt and equity are independent of the capital structure.
  7. There is no change in the firm’s investment decisions, i.e., no change in total assets.
  8. The firm’s total financing remains constant, but the proportion of debt and equity may change.



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