Capital structure decision refers to the selection of capital variety for running the business. Any business needs money for its operations. In the initial stages, it is the business owners, founders, or entrepreneurs who inject these funds. The business is liable to return these funds to these investors. The capital raised in this way is used for purchasing various assets that are essential for running the business. However, some of the assets such as the land, buildings, plant, and machinery are long lasting assets, while other assets, such as vehicles, and inventory are comparatively short term assets. In other words, the business needs money for varying duration.
Therefore, capital structure decision refers to the process of optimally combining the financing options available to a business. A business’ capital structure can be broadly divided into three categories, i.e., common equity, preferred stock, and other debts. Business enterprises usually utilize debt funds for their short term requirements, and opt for long term options such as debentures, preferred stocks, and common equity when they are planning any major expansion or purchase of long lasting assets. Such long term capital options include profits retained by the business as reserves for any impending purchase or expansion. A profit making business finds it easier to raise money by offering common equity, and preferred stocks. Unlike it, a startup may have little choice but to opt for debt route. Interest rates applicable on debt depend upon prevailing market conditions and the risk associated with the business.
Effectively, capital structure decision refers to the meticulous planning of business’ funds requirement. While planning such funds requirement, decision makers consider current requirements as well as future requirements. Long term finance options such as common equity and preferred stocks may appear as a cheap way of raising money. However, if this money is raised for short term requirements, then the earnings per share or the EPS comes down. This is because average rate of earning profits on money in the business also come down due to underutilization of these funds. More debts, on the other hand, imply more business risk because debts may crystallize suddenly forcing the business into distress sale.
Consequently, capital structure decision refers to the act of balancing profitability with viability. Borrowing in the market may appear to be an expensive way of financing business activities. However, if the business can earn more profits on borrowed funds than it pays for borrowing them, then such debts are beneficial for the business. Effectively, the business earns profits on others money. This financial process of borrowing money to earn profits is called leveraging. It is a crucial part of any capital structure decision making. There are industrial norms and ratios that indicate acceptable leveraging for any business.
Therefore, capital structure decision refers to the management’s ability in selecting the ideal option for raising capital for the business at any point of time. Such decisions have a direct impact on investor’s wealth. If EPS comes down, the demand for the business’ shares will be lower on stock markets. Consequently, the premiums on these shares will be south bound, and so will investor’s wealth. Both long term and short term financing options can have this effect. Long term financing options like common equity and preferred stock may result in ineffective utilization of funds, and consequently lower EPS. Short term financing options like borrowings from banks may lower the profits and EPS due to interest costs.