MAKING CAPITAL AND FINANCIAL AND STRUCTURE DECISIONS IN FINANCE

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There is difference between capital structure and financial structure. Capital structure may be defined as the combination of long term debt instruments which include long term loans,? debentures, preferred stock(preference shares ) and ordinary shares(including reserves and retained earnings),that constitute a firm’s financing ie capital.

The financial structure is a combination of capital structure and current liabilities which include payables and short term loans eg bank overdraft etc. The capital structure is a subset of financial structure? that represents the permanent sources of a company’s financing.

I have highlighted above what constitutes debts. Equity includes ordinary share, preferred stock and retained earnings. Ordinary share alone does not mean equity. It is a component of it.

Financial managers are concerned about ?the capital structure of a firm because when a firm has high business risk, they would want to balance this risk with a lower level of financial risk by employing lower levels of debt(leverage) in the capital structure ie a capital structure in which the cost of capital to the firm is minimized.

Hence ,at this minimum cost of capital, the net present value of new investment projects is maximized and consequently the firm value will be maximized. This minimum cost capital structure is therefore called the optimal capital structure. The question of determination of optimal capital structure is very crucial in financial management.

A balanced capital structure is also? essentially advised for? organizations ie a capital structure where values of debt(leverage) and equity are equal.

However, an improved capital structure is critical to a firm’s financial flexibility to extent that firms usually have the need to restructure their capital structures by rearranging the composition of their capital structure to either? reduce the cost of capitals or improve their overall values.

The following factors according to Ezike(2002) may affect capital structure decisions viz:

1. The Degree of financial Leverage: One ?basic issue regarding capital structure involves the question of whether a firm should issue debt or equity financing and in what proportion. Logically, this question is usually considered from the firm’s shareholders? perspective and the answer depends essentially on the firm’s level of operating income.

2. Operating income ?: If a firm is profitable enough, its capital structure decision is enhanced. This is as a result of maximum use of leverage at minimum cost which has the effect of stimulating the earning? capacity of the company. By employing leverage(ie debt financing) , a firm earns returns in excess of fixed costs of assets and sources of funds, thereby increasing the returns to ordinary shareholders. This is the concept of magnification of earnings by introducing leverage in the capital structure. The interest on debt is tax deductable.

3.Risk Return Trade-Off

A firm can potentially show increased earnings(returns) for its shareholders by increasing its level of financial risks through addition of debt in its capital structure. It is a known fact that increases in risk result to increase in cost of capital, the financial manager has to assess the trade-off between the higher returns for shareholders and higher costs of capital which may threaten the solvency of the firm.

4.Flexibility. A capital structure should be flexible and adaptable to changing conditions. This feature makes capital structure decisions responsive to changing circumstances at minimum cost and delay.

5. Cost of Capital Consideration: The financial manager must be aware of and consider the relationship between the cost of debt and capital structure. In general, investors in debt consider the debt instrument less risky if the firm has a low rather than a high proportion of debt in its capital structure. As the proportion of debt in capital increases investors require a higher return on now more risky debt. Hence, since the firm’s cost of capital is the investors’ required rate of return, the cost of debt increases as the proportion of debt in the capital structure increases.

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