NAME: MICHELLE P.

GALOPE
YEAR & SECTION: BSBA-FM4

In corporate finance, the term capital structure is used to describe the

combination of liabilities, or external sources of funds, that can be employed
to set up a business.It shows how much of a company is financed by creditors
and owners.The valuation of shares in a company is affected by the overall
cost of capital that the company uses, which in turn is determined by the
company’s capital structure. Valuation has to do with persistence to a firm’s
health. This information is valuable for the current and potential shareholders
of the firm, and quite crucial when the firm intends to acquire or to merge
with another firm, or even when it intends to raise cash. A capital structure is
comprised of two forms of financial instruments, and which has some unique
features. Capital structure is a key concept in finance that plays an intrinsic
role in the success of any business. Business owners must consider several
factors before arriving at an informed decision concerning their ideal r
capital structure. Once a business has identified what an ideal financing mix
may look like, business owners can exploit the advantages that each source
of financing has to offer toward this business growth and scaling without any
limitations.

A business operations, capital expenditures, acquisitions, and other

investments are funded using debt and equity capital. There are tradeoffs
firms have to make when they decide whether to use debt or equity to
finance operations, and managers will balance the two to find the optimal
capital structure. According to (Admin, 2021), debt capital is the money that
a person or an institution allows a business to borrow, and this amount has to
be paid back after a specified period. Debt Capital is less expensive than
and poses fewer risks than equity capital. It either comes with some security
or no. Secured Debt is the type of debt a company takes on against its
assets. The lender is free to sell the asset and gets its due as long as the
company does not try to pay the debt. Unsecured Debt is a borrowing made
by the company without pledging any type of debt as security for the loan.I
can classify the Debt Capital into three types – Term Loans, Debentures and
Bonds. Below is the descriptive view of all three terms.

● Term Loans – A type of loan extended to businesses by banks, termed

as a Term Loan, which charges interest at a fixed or floating rate set out
 in the loan agreement and are usually secured. These loans are usually
guaranteed by a concrete date to repay the money.

● Debentures – A corporate bond or a debt instrument that is offered to

the public by the company itself is known as a debenture.

● Bonds - A bond is a loan security which the government or a

corporation will etch a bond from than later will be offered to the
public. Theses instruments are presented for a certain period of time
usually about a number of years on which they mature and the issuer
pays back the original amount plus the accrued interest to the
bondholder.

On the other hand, According to the (Admin, 2021), Equity Capital is the sum
of money raised by the owners in their business. The equity of a company is
divided into various units, and each unit is called a share. The owners can sell
some of these shares to the public to raise funds. The shares are of two types-
Equity shares and Preference shares. Here is a brief description of the two
terms:

● Equity Shares – These are ordinary shares of a company that the

owners sell in the open market. Investors purchase these shares and
become stakeholders in the organisation with ownership rights. They
hold voting rights to select the company's management. They get a
percentage of the company's profits, but only after preference
shareholders get their dividend.
● Preference Shares – Preference shares enable the shareholders to
receive dividends before equity shareholders. They are entitled to a
fixed rate of compensation whenever the company declares a
dividend. They also have the right to claim repayment of capital if the
company dissolves.

Capital structure evaluation refers to the analysis of a company's capital

structure to determine the proportion of debt and equity that best suits an
entity. A company's capital structure, therefore, has a decisive influence on
its ability to raise funds, its cost of capital, and its overall risk profile. Thus,
through capital structure evaluation, a company will be able to assess which
financing option is most suitable to achieve its optimum level of financial
performance. Effective capital structure evaluation requires considering
various factors, including industry dynamics, company size, growth prospects,
and risk tolerance.

There are a variety of key factors to consider when evaluating capital

structure. These factors help a company decide on the ideal mix of debt and
equity, given their set circumstances and goals. Some commonly employed
key ratios to evaluate this structure include:

● Debt Ratio: This ratio indicates what proportion of a company’s assets is

financed through debt. A higher debt ratio indicates more leverage
and therefore increased financial risk.
● Debt-to-Equity (D/E) Ratio: This ratio determines the total debt’s
proportion to total shareholders’ equity of a company and shows how
dependent the business is on debt instead of equity financing. If this
ratio is high, it means the financial leverage and subsequently risk for
the company are also high.
● Long-term Debt to Capitalization Ratio: This ratio assesses long-term
debt in relation to total capitalization (the sum of long-term debt,
preferred stock, and equity) and helps gauge financial health.
● The WACC: is comparable to what is the average return a company is
expected to pay to its security holders. A lower WACC suggests lower
financing costs, which are good for maximizing the value of the firm.
● Equity Ratio: determines the proportion of equity within the capital
structure and thus assesses what portion of a company’s financing is
from its own shareholders rather than making use of creditors.

These ratios provide significant insight into the company’s financial position in
comparison to its competitors and industry benchmarks. These indicators will
subsequently help investors, lenders, and managers in making decisions
related to capital allocation and risk management strategies.

According to the (Team, 2024), cost of capital is the minimum return rate that
a business must earn before it can create value. It is the least amount of profit
the business must make to, at the very least, recover its capital costs. It
consists of both the costs of capitalizing on its operations and the equity the
corporation uses to finance itself. Therefore, the cost of capital greatly
depends on the company's financing - its capital structure. A company can
either rely solely on equity or debt or do so in some proportion.
The factor thereby gives an essential role for the companies and, therefore,
determines the method of its use in determining the different aspects of
capital structure. Companies look for the best mix of financing that may
provide a balanced nature of funding and the least cost of capital.

The Weighted Average Cost of Capital (WACC) is the most frequently

employed method for calculating the cost of capital. The unified
aggregation of all funding sources is evaluated and calculated regarding
the existing ratio in the firm's capital framework. The cost of capital plays a
crucial role in capital structure. Establishing the ideal capital structure for a
business poses numerous difficulties, due to the intrinsic benefits and
drawbacks associated with both debt and equity funding.

Furthermore, according to the (ReHmat, 2015), the dividend simply means the
portion of profit to be shared among the owners or shareholders of the firm.
The dividend policy of a firm sets down what proportion of earnings is paid to
the shareholders in the form of dividends and the proportion that is reinvested
back into the firm. If a capital budgeting decision is independent of a firm's
dividend policy, higher dividend payments imply a greater dependence on
external financing. Thus, the dividend policy has an effect on the choice of
financing. On the other hand, a firm's capital budgeting decision depends on
its dividend decision; hence, payment of a higher dividend will shrink the size
of the capital budget and, hence, vice versa. In such a case, the dividend
policy has an effect on the capital budgeting decision. A company dividend
policy is an act of management expressing its opinion on utilizing a
company's earnings available for distribution as dividends to its shareholders.
They would consider not only the dividends paid one year but those to be
distributed over a long period of time.
REFERENCES

Vipond, T. (2024, August 2). Capital structure. Corporate Finance Institute.

https://corporatefinanceinstitute.com/resources/accounting/capital-structure-overview/

Admin. (2022, January 9). Capital Structure: Meaning, factors, types, importance.

BYJUS. https://byjus.com/commerce/capital-structure/

Team, C. (2024, February 20). Cost of capital. Corporate Finance Institute.

https://corporatefinanceinstitute.com/resources/valuation/cost-of-capital/

Capital structure: what it means and how companies can optimize it | re:cap. (n.d.).

https://www.re-cap.com/blog/capital-structure

ReHmat, A. (2015, June 14). Capital structure & dividend policy [Slide show].

SlideShare. https://www.slideshare.net/slideshow/capital-structure-dividend-policy/

49370698