Meaning of Capital Structure

Capital Structure

Perhaps you have heard a lot about capital structure and may be wondering what it entails, and why it is important in financial management. Basically, a company needs to finance its operations and assets in one way or another. Most large corporations use a mix of equity and debt as sources of finance for their investments and business operations. That is primarily what capital structure is all about – components of the firm’s financial capital. Read on to understand more clearly the meaning of capital structure in financial management.

Capital structure refers to the mix of equity and debt that a company uses to finance its operations and assets. For a company to continue operating normally while still growing, it needs capital. This comes primarily from debt or equity or both. Some of the advantages of using debt financing include: (1) debt interests are tax deductible, while dividends from shares are not deductible; this lowers the overall cost of debt. (2) Debt has a fixed return, such that the company does not need to share profits with shareholders.

Debt as a source of financing also has several disadvantages: (1) It increases risks for the company, and (2) the bank may go bankrupt if it is not able to repay its debts during hard economic times.

Companies that have relatively little business risks can use more debt, but if the business operates in a risky and volatile environment it should minimize the use of debts to finance its operations.

When Safaricom entered into a licensing deal to enter Ethiopia in 2022, it had the decision to use either equity or debt to finance its operations in Ethiopia. The company did not have enough reserves to invest in the project, but it was able to borrow a bank loan of $400 million to finance the project. By September 2022, Safaricom’s total debt amounted to KSH76.9 billion, against cash and cash equivalents of KSH26.4 billion. Within the same year, the company had a total of KES139.5 billion. This shows that the company has more equity than debt in its capital structure at 64% equity and 36% debt.

Due to the high equity investment and huge profits, Safaricom has been paying 80% of its net income to shareholders as dividends, while 20% is reinvested in infrastructure and retained earnings.

An optimal capital structure refers to the structure which enables a company to maximize stock price. Some companies have a target capital structure of 45% debt and 55% equity; others that have a stable business can take 60% debt and 40% equity. The trade-off theory of capital structure suggests that managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost of capital, which in turn maximizes company value. An optimal capital structure seeks a balance between the cost-effectiveness of borrowing and risk minimization of equity.

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