Capital Structure Of A Company

960 Words Nov 30th, 2015 4 Pages

Capital structure is the proportion of debt and equity in which a corporate finances its business. The capital structure of a company/firm plays a very important role in determining the value of a firm. There are various theories which propagate the ‘ideal’ capital mix / capital structure for a firm.

A corporate can finance its business mainly by 2 means i.e. debts and equity. However, the proportion of each of these could vary from business to business. A company can choose to have a structure which has 50% each of debt and equity or more of one and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company. Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest obligations etc.
For finding the optimum capital structure in order to maximize shareholder’s wealth or value of the firm, different theories (approaches) have evolved.


Traditional Approach

Traditional approach to capital structure suggests that there exist an optimal debt to equity ratio where the overall cost of capital is the minimum and market value of the firm is the maximum. On either side of this…
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