Capital structure is a mixture of debt and equity, this decision is very important for a company as it is a cost for the company because it is borrowed money. This decision is very critical for the company because of different tax implications of debt equity and also the effect of corporate taxes on the profitability and revenues of the firm. Firms must be careful in their borrowing activities in order to avoid financial distress, excessive risk and even bankruptcy.
A firm's debt/equity ratio also effect the firm's borrowing costs and reduces its’ value to shareholders. The debt/equity ratio also measures the company's financial leverage by dividing company’s’ total liabilities by stockholders' equity. It tells that how much proportion of equity and debt has the company used to finance its assets. In the financing decision a company has to decide its capital structure. Here the debt & equity ratio is decided.
The capital structure decision or a financing decision shown on the left side indicates Liabilities on the balance sheet while investment decision shown on the right side indicates Assets on the balance sheet. The capital structure shows the relative relationship between debt & equity. Capital structure does not have much impact on the earnings of firms but it surely affects the share of Earning attainable for the equity share holders
OPTIMAL CAPITAL STRUCTURE
The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its value. i.e, the optimal capital structure for a company is the one which proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firm’s cost of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of its tax deductibility. However, it is seldom the optimal structure for as debt increases, it increases the company’s risk.
The short and long term debt ratio of a company should also be considered while examining the capital structure. Capital structure is most commonly referred as a firm’s debt-to-equity ratio, which gives an insight into the level of risk of a company for the potential investors. Estimating an optimal capital is a key requirement of a company’s corporate finance department.
The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases.
A company's ratio of short and long-term debt should...