Question

1. What do we mean by the term “capital structure”?

2. Why is a firm’s capital structure important?

3. What is the firm’s target capital structure, and what is achieved at that target?

Answer 1

1. What do we mean by the term “capital structure”?

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.

2. Why is a firm’s capital structure important?

• Value Maximization

Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.

• Cost Minimization

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund 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.

3. What is the firm’s target capital structure, and what is achieved at that target?

A company’s target capital structure refers to capital which the company is striving to obtain. In other words, target capital structure describes the mix of debt, preferred stock and common equity which is expected to optimize a company’s stock price. As a company raises new capital, it will focus on maintaining this target or optimal capital structure. It is important to note is that while the target structure is the capital structure that will optimize the company's stock price, it is also the capital structure that minimizes the company's weighted-average cost of capital (WACC).