Q.What is Capital Structure? Explain the factors that determine a sound capital structure.

This is one of the most commonly asked essay questions in the Andhra Pradesh Intermediate Commerce paper on this chapter.

Capital structure refers to the mix or proportion of a firm's long-term sources of finance — mainly owned funds such as equity share capital, preference share capital and reserves, and borrowed funds such as debentures and long-term loans — used to finance its total assets. It is narrower than the overall financial structure, which also includes short-term liabilities. The objective behind planning capital structure is to arrive at an optimum mix that keeps the overall cost of capital reasonably low and financial risk within safe limits, while maximising the value of the firm and the return to equity shareholders.

Several factors are weighed together while deciding a sound capital structure. Cost of capital is an important starting point, since debt is often cheaper than equity because interest is a fixed, tax-deductible charge while dividend is not; a firm therefore uses a reasonable proportion of debt to keep its overall cost down. Risk is the natural counterweight, because debt carries a fixed obligation to pay interest and repay principal regardless of profit, so too much debt raises financial risk, and firms with steady earnings can safely carry more debt than those with fluctuating income.

Control is another factor, since issuing more equity shares can dilute existing owners' voting control, making some promoters prefer debt or preference capital instead. Flexibility and the firm's cash-flow ability to service fixed interest and repayment commitments matter too, along with the nature and size of the business, prevailing capital-market conditions, government regulations on the issue of shares and debentures, and tax treatment, since interest reduces taxable profit while dividend does not. …