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Capital structure is the way in which a company finances its assets by employing equity, debt and other financial aids. The company has to strike a balance between, the ratio of equity and debt and other financial aids. A company needs to maintain an optimal capital structure, where the market value per share is maximum and the cost of capital is minimum.
The company must consider the cost of capital. Cost of capital is defined as the cost incurred by a corporation to raise its capital. If there are no taxes, then the average cost of capital would be equal to the average return that an investor in a corporation expects to earn after having invested proportionately in the company.
The appropriate capital structure of a company should have the following features.
- Profitability or Return
- Solvency or Risk
- Conversation and Capacity
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for today’s theory and study of capital structure. It is viewed as a theoretical since it assumes important factors in the capital structure decision. The theorem states that, ‘in a perfect market, how a firm is financed is irrelevant to its value.’
Financial Leverage: The use of fixed-charges sources of funds, such as debt and preference capital along with the owners’ capital structure, is described as financial leverage or gearing or trading on equity.
The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus or deficit will increase or decrease the return on the owner’s equity. The rate of return on the owner’s equity is levered above or below the rate of return on total assets.
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