Considerations for Capital Structure

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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 it...

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...ge cost of capital (WACC) is minimized the maximizes the value of the firm increases. This means that optimal capital structure for the firm is that which minimizes WACC.
The capital structure of a firm shows how it finances its operations and grows by using distinctive sources of funds. Debt for a company comes in the form of bonds issued or long-term notes payable, on the other hand equity is sorted as common stock, preferred stock and retained earnings. Short-term debt for example working capital requirements are also considered to be a part of a capital structure. When capital structure of a firm is talked off, it is understood that they are referring to a firm's debt/equity ratio, which provides understanding about how risky a company is. Usually a company which is more heavily financed by using debt poses more risk, as the firm is relatively highly levered.

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