1.

what do you understand by capital structure of a

corporation
Capital structure is essentially concerned with how the firm
decides to divide its cash flows into two broad components, a
fixed component that is earmarked to meet the obligations toward
debt capital and a residual component that belongs to equity
shareholders-P. Chandra.
Concept of Capital Structure:
The relative proportion of various sources of funds used in a
business is termed as financial structure. Capital structure is a
part of the financial structure and refers to the proportion of the
various long-term sources of financing. It is concerned with
making the array of the sources of the funds in a proper manner,
which is in relative magnitude and proportion.
The capital structure of a company is made up of debt and equity
securities that comprise a firms financing of its assets. It is the
permanent financing of a firm represented by long-term debt,
preferred stock and net worth. So it relates to the arrangement of
capital and excludes short-term borrowings. It denotes some
degree of permanency as it excludes short-term sources of
financing.
Again, each component of capital structure has a different cost to
the firm. In case of companies, it is financed from various sources.
In proprietary concerns, usually, the capital employed, is wholly

contributed by its owners. In this context, capital refers to the

total of funds supplied by bothowners and long-term creditors.
The question arises: What should be the appropriate proportion
between owned and debt capital? It depends on the financial
policy of individual firms. In one company debt capital may be nil
while in another such capital may even be greater than the owned
capital. The proportion between the two, usually expressed in
terms of a ratio, denotes the capital structure of a company.
Definition of Capital Structure:
Capital structure is the mix of the long-term sources of funds used
by a firm. It is made up of debt and equity securities and refers to
permanent financing of a firm. It is composed of long-term debt,
preference share capital and shareholders funds.
Various authors have defined capital structure in different ways.
Some of the important definitions are presented below:
According to Gerestenberg, capital structure of a company refers
to the composition or make up of its capitalization and it includes
all long term capital resources viz., loans, reserves, shares and
bonds. Keown et al. defined capital structure as, balancing the
array of funds sources in a proper manner, i.e. in relative
magnitude or in proportions.

In the words of P. Chandra, capital structure is essentially

concerned with how the firm decides to divide its cash flows into
two broad components, a fixed component that is earmarked to
meet the obligations toward debt capital and a residual
component that belongs to equity shareholders.
Hence capital structure implies the composition of funds raised
from various sources broadly classified as debt and equity. It may
be defined as the proportion of debt and equity in the total capital
that will remain invested in a business over a long period of time.
Capital structure is concerned with the quantitative aspect. A
decision about the proportion among these types of securities
refers to the capital structure decision of an enterprise.
Importance of Capital Structure:
Decisions relating to financing the assets of a firm are very crucial
in every business and the finance manager is often caught in the
dilemma of what the optimum proportion of debt and equity
should be. As a general rule there should be a proper mix of debt
and equity capital in financing the firms assets. Capital structure
is usually designed to serve the interest of the equity
shareholders.
Therefore instead of collecting the entire fund from shareholders a
portion of long term fund may be raised as loan in the form of
debenture or bond by paying a fixed annual charge. Though these
payments are considered as expenses to an entity, such method

of financing is adopted to serve the interest of the ordinary shareholders in a better way.
2. The importance of designing a proper capital
structure is explained below:
Value Maximization:
Capital structure maximizes the market value of a firm, i.e. in a
firm having a properly designed capital structure the aggregate
value of the claims and ownership interests of the shareholders
are maximized.
Cost Minimization:
Capital structure minimizes the firms cost of capital or cost of
financing. By determining a proper mix of fund sources, a firm can
keep the overall cost of capital to the lowest.
Increase in Share Price:
Capital structure maximizes the companys market price of share
by increasing earnings per share of the ordinary shareholders. It
also increases dividend receipt of the shareholders.
Investment Opportunity:
Capital structure increases the ability of the company to find new
wealth- creating investment opportunities. With proper capital
gearing it also increases the confidence of suppliers of debt.

Growth of the Country:

Capital structure increases the countrys rate of investment and
growth by increasing the firms opportunity to engage in future
wealth-creating investments.
Patterns of Capital Structure:
There are usually two sources of funds used by a firm: Debt and
equity. A new company cannot collect sufficient funds as per their
requirements as it has yet to establish its creditworthiness in the
market; consequently they have to depend only on equity shares,
which is the simple type of capital structure. After establishing its
creditworthiness in the market, its capital structure gradually
becomes complex.
A complex capital structure pattern may be of following
forms:
i. Equity Shares and Debentures (i.e. long term debt including
Bonds etc.),
ii. Equity Shares and Preference Shares,
iii. Equity Shares, Preference Shares and Debentures (i.e. long
term debt including Bonds etc.).
However, irrespective of the pattern of the capital structure, a
firm must try to maximize the earnings per share for the equity
shareholders and also the value of the firm.

3. sources of capital
here are various sources of finance such as equity, debt,
debentures, retained earnings, term loans, working capital
loans, letter of credit, euro issue, venture funding etc. These
sources are useful in different situations. They are classified
based on time period, ownership and control, and their source of
generation.
Sources of finance are the most explored area especially for the
entrepreneurs about to start a new business. It is perhaps the
toughest part of all the efforts. There are various sources of
finance classified based on time period, ownership and control,
and source of generation of finance.
Having known that there are many alternatives of finance or
capital, a company can choose from. Choosing right source and
the right mix of finance is a key challenge for every finance
manager. The process of selecting right source of finance involves
in-depth analysis of each and every source of finance. For
analyzing and comparing the sources of finance, it is required to
understand all characteristics of the financing sources. There are
many characteristics on the basis of which sources of finance are
classified.
On the basis of a time period, sources are classified into long
term, medium term, and short term. Ownership and control
classify sources of finance into owned capital and borrowed
capital. Internal sources and external sources are the two sources
of generation of capital. All the sources of capital have different

characteristics to suit different types of requirements. Lets

understand them in a little depth.
ACCORDING TO TIME-PERIOD:
Sources of financing a business are classified based on the time
period for which the money is required. Time period is commonly
classified into following three:
o Long Term Sources of Finance: Long-term financing
means capital requirements for a period of more than 5
years to 10, 15, 20 years or maybe more depending on
other factors. Capital expenditures in fixed assets like plant
and machinery, land and building etc of a business are
funded using long-term sources of finance. Part of working
capital which permanently stays with the business is also
financed with long-term sources of finance. Long term
financing sources can be in form of any of them:
o Share Capital or Equity Shares
o Preference Capital or Preference Shares
o Retained Earnings or Internal Accruals
o Debenture / Bonds
o Term Loans from Financial Institutes, Government, and
Commercial Banks
o Venture Funding
o Asset Securitization
o International Financing by way of Euro Issue, Foreign
Currency Loans, ADR, GDR etc.
o Medium Term Sources of Finance: Medium term
financing means financing for a period of 3 to 5 years.
Medium term financing is used generally for two reasons.
One, when long-term capital is not available for the time
being and second, when deferred revenue expenditures
like advertisements are made which are to be written off
over a period of 3 to 5 years. Medium term financing
sources can in the form of one of them:
o Preference Capital or Preference Shares
o Debenture / Bonds
o Medium Term Loans from

o
o
o

o
o
o
o
o
o
o
o

Financial Institutes
Government, and
Commercial Banks
Lease Finance
Hire Purchase Finance
Short Term Sources of Finance: Short term financing
means financing for a period of less than 1 year. Need for
short term finance arises to finance the current assets of a
business like an inventory of raw material and finished
goods, debtors, minimum cash and bank balance etc. Short
term financing is also named as working capital
financing. Short term finances are available in the form of:
Trade Credit
Short Term Loans like Working Capital Loans from
Commercial Banks
Fixed Deposits for a period of 1 year or less
Advances received from customers
Creditors
Payables
Factoring Services
Bill Discounting etc.

o ACCORDING TO OWNERSHIP AND CONTROL:

o Sources of finances are classified based on ownership and
control over the business. These two parameters are an
important consideration while selecting a source of finance
for the business. Whenever we bring in capital, there are two
types of costs one is interest and another is sharing of
ownership and control. Some entrepreneurs may not like to
dilute their ownership rights in the business and others may
believe in sharing the risk.
o Owned Capital: Owned capital is also referred as equity
capital. It is sourced from promoters of the company or
from the general public by issuing new equity shares.
Business is started by the promoters by bringing in the

o
o
o
o
o

required capital for a startup. Owners capital is sourced

from following sources:
Equity Capital
Preference Capital
Retained Earnings
Convertible Debentures
Venture Fund or Private Equity

Further, when the business grows and internal accruals like

profits of the company are not enough to satisfy financing
requirements, the promoters have a choice of selecting
ownership capital or non-ownership capital. This decision is up
to the promoters. Still, to discuss, certain advantages of equity
capital are as follows:
o It is a long term capital which means it stays permanently
with the business.
o There is no burden of paying interest or installments like
borrowed capital. So, the risk of bankruptcy also reduces.
Businesses in infancy stages prefer equity capital for this
reason.
o Borrowed Capital: Borrowed capital is the capital
arranged from outside sources. These include the
following:
o Financial institutions,
o Commercial banks or
o The general public in case of debentures.
In this type of capital, the borrower has a charge on the assets
of the business which means the borrower would be paid by
selling the assets in case of liquidation. Another feature of
borrowed capital is regular payment of fixed interest and
repayment of capital. Certain advantages of borrowing capital
are as follows:
o There is no dilution in ownership and control of business.
o The cost of borrowed funds is low since it is a deductible
expense for taxation purpose which ends up saving on
taxes for the company.
o It gives the business a leverage benefit.
ACCORDING TO SOURCE OF GENERATION:

o Internal Sources:Internal source of capital is the capital

which is generated internally from the business. Internal
sources are as follows:
o Retained profits
o Reduction or controlling of working capital
o Sale of assets etc.
The internal source has the same characteristics of owned
capital. The best part of the internal sourcing of capital is that
the business grows by itself and does not depend on outside
parties. Disadvantages of both equity capital and debt capital
are not present in this form of financing. Neither ownership is
diluted nor fixed obligation / bankruptcy risk arises.
o External Sources: An External source of finance is the
capital which is generated from outside the business. Apart
from the internal sources finance, all the sources are
external sources of capital.
Deciding the right source of finance is a crucial business decision
taken by top-level finance managers. The wrong source of finance
increases the cost of funds which in turn would have a direct
impact on the feasibility of project under concern. Improper match
of the type of capital with business requirements may go against
the smooth functioning of the business. For instance, if fixed
assets, which derive benefits after 2 years, are financed through
short-term finances will create cash flow mismatch after one year
and the manager will again have to look for finances and pay the
fee for raising capital again.
4. factors affecting cost of capital
These are the factors affecting cost of capital that the company
has control over:
1. Capital Structure Policy
As we have been discussing above, a firm has control over its
capital structure, targeting an optimal capital structure. As more
debt is issued, the cost of debt increases, and as more equity is
issued, the cost of equity increases.

2. Dividend Policy
Given that the firm has control over its payout ratio, the
breakpoint of the MCC schedule can be changed. For example, as
the payout ratio of the company increases the breakpoint
between lower-cost internally generated equity and newly issued
equity is lowered.
3. Investment Policy
It is assumed that, when making investment decisions, the
company is making investments with similar degrees of risk. If a
company changes its investment policy relative to its risk, both
the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company
has no control over:
1. Level of Interest Rates
The level of interest rates will affect the cost of debt and,
potentially, the cost of equity. For example, when interest rates
increase the cost of debt increases, which increases the cost of
capital.
2. Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase,
the cost of debt decreases, decreasing the cost of capital.
5. how does the cost of capital influence the capital
structure
The primary factors that influence a company's capital-structure
decision are:
1. Business Risk

Excluding debt, business risk is the basic risk of the company's

operations. The greater the business risk, the lower the optimal
debt ratio.
As an example, let's compare a utility company with a retail
apparel company. A utility company generally has more stability
in earnings. The company has les risk in its business given its
stable revenue stream. However, a retail apparel company has
the potential for a bit more variability in its earnings. Since the
sales of a retail apparel company are driven primarily by trends in
the fashion industry, the business risk of a retail apparel company
is much higher. Thus, a retail apparel company would have a
lower optimal debt ratio so that investors feel comfortable with
the company's ability to meet its responsibilities with the capital
structure in both good times and bad.
2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax
rate is high, using debt as a means of financing a project is
attractive because the tax deductibility of the debt payments
protects some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It
should come as no surprise that companies typically have no
problem raising capital when sales are growing and earnings are

strong. However, given a company's strong cash flow in the good

times, raising capital is not as hard. Companies should make an
effort to be prudent when raising capital in the good times, not
stretching its capabilities too far. The lower a company's debt
level, the more financial flexibility a company has.
The airline industry is a good example. In good times, the industry
generates significant amounts of sales and thus cash flow.
However, in bad times, that situation is reversed and the industry
is in a position where it needs to borrow funds. If an airline
becomes too debt ridden, it may have a decreased ability to raise
debt capital during these bad times because investors may doubt
the airline's ability to service its existing debt when it has new
debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The
more conservative a management's approach is, the less inclined
it is to use debt to increase profits. An aggressive management
may try to grow the firm quickly, using significant amounts of
debt to ramp up the growth of the company's earnings per share
(EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance
that growth through debt, borrowing money to grow faster. The

conflict that arises with this method is that the revenues of

growth firms are typically unstable and unproven. As such, a high
debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance
growth as its revenues are stable and proven. These firms also
generate cash flow, which can be used to finance projects when
they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's
capital-structure condition. Suppose a firm needs to borrow funds
for a new plant. If the market is struggling, meaning investors are
limiting companies' access to capital because of market concerns,
the interest rate to borrow may be higher than a company would
want to pay. In that situation, it may be prudent for a company to
wait until market conditions return to a more normal state before
the company tries to access funds for the plant.
6. how does financing of mncs belonging to develop
country help to both country
Multinational Corporations in Developing Countries
Arguments for Multinational Corporations in developing countries.

They Provide an inflow of capital into the developing country.

E.g. the investment to build the factory is counted as a capital
flow on the financial account of the balance of payments. This

capital investment helps the economy develop and increase its

productive capacity.

The Harod Domar model of growth suggests that this level of

investment is important for determining the level of economic
growth.

The inflows of capital help to finance a current account

deficit. (foreign investment enables developing countries to buy
imports)

Multinational corporations provide employment. Although

wages seem very low to us, people in developing countries often
see these new jobs as preferable to working as a subsistence
farmer with even lower income.

Multinational firms may help improve infrastructure in the

economy. They may improve the skills of their workforce. Foreign
investment may stimulate spending in infrastructure such as
roads and transport.

Multinational firms help to diversify the economy away from

relying on primary products and agriculture which are often
subject to volatile prices and supply.
7. Tax harmonization
The process of making taxes similar across a geographic region
by increasing taxes in lower-tax areas to match the higher-tax
areas.
Tax harmonization is making taxes identical or at least similar in
a region. In practice, it usually means increasing tax in low-tax
jurisdictions, rather than reducing tax in high-tax jurisdictions or a
combination of both. The best example is the European
Unionwhere all countries must have a value added tax of at least
15%.

The debate on tax competition opposes

those who praise its positive effect on
government efficiency, and those who
accuse it of distorting public choices,
inducing inequality but also undermining
the functioning of markets. These two polar
versions coexist in the European Union.
Since decisions on taxation require
unanimity, it is not surprising that tax
cooperation remains difficult. Still, the
argument that tax distortions undermine
the single market has justified some
harmonization in the area of indirect
taxation (Value Added Tax, excise duties);
much less harmonization, however, has
happened on the direct taxation of capital
and labor.
The sovereign debt crisis that started in
2009 has given an impetus to the debate
on tax harmonization, for three reasons:
Governments have been obliged to rapidly
raise taxes while facing international tax
competition and domestic discontent
concerning the distribution of the burden;
Emergency assistance to crisis countries
has sometimes been considered illegitimate
given the low levels of taxation in some
countries for companies or wealthy
individuals;
The need for a fiscal capacity has
emerged as a complement to the monetary
union and to the banking union.
It should be noted at this stage that
although they are often considered as
synonymous, the words coordination,
cooperation, convergence and

harmonization cover somewhat different

concepts. Tax harmonization (e.g. the
minimum standard VAT rate, or common
rules embodied in different directives on
the corporate taxation), is a form of
coordination. The Common Consolidated
Corporate Tax Base project (CCCTB)
envisages a harmonization of CIT bases,
but also some cooperation through the
consolidation and apportionment of tax
bases.3 As for convergence, it is a broader
concept that is compatible with both tax
coordination and tax competition. In the
following, we concentrate on tax
harmonization and cooperation.