Question

What is meant by capital structure?

Answer 1

Capital structure refers to the combination of borrowed funds and owners’ fund that a firm uses for financing its fund requirements. Herein, borrowed funds comprise of loans, public deposits, debentures, etc. and owners’ fund comprise of preference share capital, equity share capital, retained earning etc. Generally, capital structure is simply referred as the combination of debt and equity that a firm uses for financing its funds. It is calculated as the ratio of debt and equity or the proportion of debt in the total capital used by the firm. Algebraically,

The proportion of the debt and equity used by the firm affects its financial risk and profitability. While on one hand, debt is a cheaper source of finance than equity and lowers the overall cost of capital but on the other hand, higher use of debt, increases the financial risk for the firm. Thus, the decision regarding the capital structure should be taken with utmost care. Capital structure is said to be optimal when the proportion of debt and equity used is such that the earnings per share increases.