Question

Why is Capital Structure so important? Furthermore, why does a firms Capital Structure matter to itself?

Answer 1

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.

Importance of capital structure:

1. 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.

2. 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.

3. 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.

4. 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.

5.Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.

Firm's capital structure matter to itself because:

It influences everything from the firm’s risk profile, how easy it is to get funding, how expensive that funding is, the return its investors and lenders expect, and its degree of insulation from both microeconomic business decisions and macroeconomic downturns.