>> June 9, 2009
Capital structure may be defined as the mixture of resources of company in which include equity share capital, pref. shares capital and long term debts. It is the duty of finance manager to make finance structure of company and provides the fund for completing the need of company in short period and in long period. But before choosing appropriate proportion of capital sources in capital structure. Will you consider the different factors which affect capital structure of company ?
Analyze these factors of capital structure and then make best structure of capital in your balance sheet.
Finance manager has to redesign capital structure of company with effective way so that shareholders wealth become maximum and cost of capital becomes minimum. There are three points , elements and factors which affects capital structure .
First – Risk
Risk means risk of insolvency or bankruptcy. If company takes loan in the form of debenture or other long term loan , then company has to pay fixed charge in the form of interest and it must be payable , even company earns profit or not and company also repayment of this loan because , this is secured loan and if company will not repay that amount , creditors can sell the assets under mortgage and collect their money . So , if company faces financial crisis , then higher proportion of debt content in capital structure may dangerous for company.
2nd Cost of Capital
Second point also must be considered by finance manager, what is the cost of capital, company should try to collect fund from that resource whose cost of capital must be minimum from other resources. If company gets fund debt and pref. shares and pay high cost of capital, then it may possible that equity shareholders also demand for higher dividend . So, remember also this point before selecting any resource as company’s capital structure part .
If company issue only further equity shares for getting fund , then new shareholders also can vote for selecting board of directors and controlling power may go to other hands . For stability of company , it is very necessary to choose optimum mix of resources so that control must be in same hand for consistency in the decisions of company.
We can explain optimum and appropriate capital structure with following example
Suppose if a company earn $ 10 before interest 1% , tax 50% after interest and pref. dividend 50 % after interest and tax charges on profit and if company needs 100 $ , company already has 100 $ equity share capital . Company is free to decide to get this fund from any one of different resources like issue of equity shares, or issue of pref. shares or issue of debenture. We will show that in which alternative the earning per shares will be highest.
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