Question

Research, define, describe, and explain the above-mentioned (Minimum 250 words answer for each questions)

Explain capital structure.

Answer 1

Capital structure :

Capital structure is a mix of debt, equity and preference capital that finances the operations of a business.

The capital structure helps us understand what type of funding does the business use to fund the operations. As an investor , we might be interested to know, what type of funding the business is dependent on. Too much reliance on debt, may bring upon the risk of bankruptcy on a firm , hence investors steer clear of these firms which are heavily dependent on debt. Although a business should have an optimum level of debt in it's capital structure as debt is cheap and the interest paid on debt is tax deductible. Debt helps a company to retain ownership unlike equity, which leads to dilution of ownership within a company. The goal of the management of a company is to have an optimum level of debt and equity which is also known as the optimal capital structure.  

The debt holders enjoy priority in the event of bankruptcy and are paid first , before anything is paid off to equity and preference holders. any failure to pay the debt holders will result in bankruptcy of the firm.So, the capital structure helps to determine the level of risk in the company. Debt provides interest tax shield which increases the returns on the operations.

An aggressive capital structure has too much debt but it can also lead to higher growth rates. A conservative capital structure leads to lower growth rates and the level of debt is too low. The optimal capital structure , results  in the minimization of the cost of capital and the maximization of the share price. A favorable debt/ equity ratio helps attract the investors.

Investors can monitor a company's capital structure by looking into the debt/ equity ratio and comparing it with the peers.