Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm.
It is composed of long-term debt, preference share capital and shareholders’ funds. It also refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.
In essence, a firm’s capital structure is the composition or structure of its liabilities. For example, if company A sells N20 billion in equity and N80 billion in debt, the company is said to be 20% equity-financed and 80% debt-financed.
Is there a perfect Debt-equity relationship?
In real life, there is no magic proportion of debt that a company can take on in its books. The debt-equity relationship varies according to industries involved, a company’s line of business and its stage of development.
However, because investors are better off putting their money into companies with strong balance sheets, logically, these companies should have, generally speaking, lower debt and higher equity levels.
The advantages of designing a proper capital structure are outlined below:
Value Maximisation
Capital structure maximises the market value of a firm. What this means is that in a firm having a properly designed capital structure, the aggregate value of the claims and ownership interests of the shareholders are maximised.
Cost Minimization
Capital structure minimises the firm’s cost of capital or cost of financing. By determining a proper mix of funding sources, a firm can keep the overall cost of capital to the lowest.
Increase in Share Price
Capital structure maximizes the company’s market price of share by increasing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.
Investment Opportunity
Capital structure increases the ability of the company to find new wealth-creating investment opportunities. With proper capital gearing, it also increases the confidence of suppliers of debt.
Growth of the Country
Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.