Question

What effect does capital structure have on a company's health and name each type? What benefits come from each?

Answer 1

The capital of any business comprises of debt and equity.Debt represents borrowed capital and hence it is a liability for the business. This can be in the form of bonds debentures or loans taken from banks and Financial Institutions. This carries a fixed rate of interest and hence it is a burden on the earnings of the business. Also the amount has to be repaid at maturity and hence it carries a risk of default.

The benefit of using debt is that interest is tax deductible and so it reduces the cost of Finance. Also it does not dilute the ownership rights of the shareholders.

Equity represents own funds and so the biggest benefit is that the amount need not be repaid if the firm has no funds at the time of liquidation. The Other benefit of equity is that it does not carry a fixed rate of return and the amount of dividend paid to the shareholders is at the discretion of the management. However cost of equity is very high and so excess equity will increase the cost of capital.

An organisation should have a good mix of debt and equity and too much debt will lead to high risk and liquidity problems. Too much of equity is also not healthy because that implies increasing the cost of funds and also dilution of ownership.