Question

Explanation of the various views of optimal capital structure.300 words

Answer 1

An optimal capital structure is one that maximized the earnings and value of shareholders. It is a mix of debt and capital in such a ratio that will minimize the overall cost of capital.

Distinct types of capital structure as follows:-

1. Horizontal Capital structure: It is a capital structure where the firm employs zero debt components and whole capitalization is done via equity shares and retrained earnings only. This structure of capital is quite stable and the probability of disturbance is very low. Owners funds if the only source of funds available to firms in this capital structure.

2. Vertical Capital structure: Vertical capital structure is contrary to the horizontal capital structure which employs a very little amount of equity funds. A major portion of capital is raised through debt and only a small portion of owner funds is taken as it is necessary for every organization. All increments in capital structure are done entirely using debt funds.

3. Pyramid Shaped capital structure: It is the one where the major portion in capital structure is of equity funds and retained earnings which are ploughed back into the firm consistently over the years. The cost associated with retained earnings and share capital funds is comparatively low to debt funds. This structure is more commonly used by conservative firms which are risk-averse in nature.

4. Inverted Pyramid-shaped capital structure: This capital structure is just the opposite of a Pyramid-shaped capital structure. It employs a relatively low level of share capital and retained earnings. Large amount of capitalization is done using the debt funds and is commonly used by large-scale organizations.