Importance of Capital Structure

The importance or significance of Capital Structure:

1. Increase in value of the firm: A sound capital structure of a company helps to increase the market price of shares and securities which, in turn, lead to an increase in the value of the firm.

2. Utilization of available funds: A good capital structure enables a business enterprise to utilize the available funds fully. A properly designed capital structure ensures the determination of the financial requirements of the firm and raises the funds in such proportions from various sources for their best possible utilization. A sound capital structure protects the business enterprise from over-capitalization and under-capitalization.

3. Maximization of return: A sound capital structure enables management to increase the profits of a company in the form of higher return to the equity shareholders, i.e., an increase in earnings per share. This can be done by the mechanism of trading on equity, i.e., it refers to an increase in the proportion of debt capital in the capital structure, which is the cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’ fund + long-term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimization of cost of capital: A sound capital structure of any business enterprise maximizes shareholders’ wealth through minimization of the overall cost of capital. This can also be done by incorporating long-term debt capital in the capital structure, as the cost of debt capital is lower than the cost of equity or preference share capital since the interest on debt is tax-deductible.

5. Solvency or liquidity position: A sound capital structure never allows a business enterprise to go for too much raising of debt capital because, at the time of poor earnings, the solvency is disturbed for compulsory payment of interest to the debt supplier.

6. Flexibility: A sound capital structure provides a room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling: A good capital structure does not allow the equity shareholders' control on business to be diluted.

8. Minimization of financial risk: If the debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase. A sound capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the capital structure.

🎶