Definition:

The term capital structurerefers to the composition or make-up of the amount of long-term financing.According to Gretenberg,capital structure of a company refers to the make up of its capitalization.acc to him,it means the type of securities to be issued and the proportionate amounts that make up the

capitalization.Capital structure includes all the long term funds consisting of share capital,debentures,bonds,loans and reserves.Long term funds can be obtained from-

1. Owners:-consists of equity shares,preference shares and retained profits.

2. Borrowers:-includes debentures and other long-term borrowing.

. Thus,capital structure refers to a mixture of a variety of long term sources of funds and equity shares including reserves and surpluses of an enterprise.

Optimal capital structure refers to the particular combination that minimizes the cost of capital while maximizing the stock price. Practicing managers have a belief in optimal capital structure owing to tax advantages associated with corporate borrowings.they feel that a sound capital structure, besides conservatism, must ensure profitability, solvency, flexibility and effective control.

In deciding the capital structure of the company,proportion of capital to be raised by issue of shares and debentures has to be decided.Here,the ratio between owners capital(equity)and debt capital is decided. .

It is to be noted that the shareholders bear the risk in carrying out of business activities as they are paid dividend out of profit.Irrespective of profit or loss,interest is paid on funds raised through loans.Investors with a psychology of regular source of income invest their funds in debentures and loans.Those who are adventurous invest their funds in shares.For the purpose of arranging capital a company tries to avail of the benefits from psychology of both shareholders and debenture holders.

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Factors Determinig Capital Structure

1. NATURE OF BUSINESS ENTERPRISE:- In case of more risk involved as in case of a manufacturing enterprise-funds should be raised through issue of shares.If the business risk is higher, the optimal capital structure is required.where less risk is involved as in case of trading concerns,funds should be obtained through issue of debentures or loans.A financially sound enterprise should raise its funds through issue of debentures,as it pays dividend at rates higher than the rate of interest that it has to pay.

2. PURPOSE FOR WHICH FINANCE IS NEEDED:-funds must be raised through issue of shares for purchase of fixed or for unproductive purposes.For working capital needs,funds must be raised through loans.For productive needs,funds should be raised through borrowings.

3. TRADING ON EQUITY:-trading means taking dvantage and equity means ownership of funds.thus trading on equity means borrowing funds at reasonable rates with the help of share capital.For an enterprise to enable to follow the policy of trading on equity ,it must satisfy the following requirements-

It should be reputed established enterprise.

The rate of earnings should be higher than the rate of interest and the rate of preference dividend.

The companys earnings should be stable and regular to pay at least the interest on debentures.

There should be sufficient fixed assets to offer as security to the lenders.

It should have an assured cash inflow.

4-EXERCISE OF CONTROL:-if the management wants to retain the management and control of the company,it should obtain its funds through loan,as issuing shares will mean granting voting rights to outsiders and risking own control.

5-NEED FOR FLEXIBILITY:- Depends on how easy a business can arrange finance on reasonable terms under adverse conditions. A good capital structure should be flexible so that adjustments can be made whenever the need arises.Debentures and preference shares can be paid off whenever the company feels necessary.but equity shares cannot be paid off during the life-time of a company.Flexibility in raising finance will be influenced by the economic environment(availability of savers and interest rates)and the financial position of the business.

6-PERIOD OF FINANCING:-equity shares are preferable for raising funds for permanent investment for longer periods.When funds are required for a medium period or a short one,debentures and preference shares are better.

7-NATURE AND ATTITUDE OF INVESTORS:-equity shares can be issued to raise funds for adventurous investors while,debentures and preference shares are necessary to attract cautious investors who prefer safety of investment and a fixed return.

8-STATUTORY REQUIREMENTS:-legal provisions must be observed while designing the capital structure.for example,the Banking Regulation Act permits the banking companies to issue only equity shares.

9-CAPITAL MARKET CONDITIONS:-if it is a period of depression,investors will not be interested in subscribing equity shares.In case of a boom period,investors will be ready to take risks and invest in equity shares.

10-COST OF RAISING FUNDS:-issuing equity shares is costlier than the issue of preference shares and debentures.The company should compare cost and take decisions accordingly.

11-GOVERNMENT TAXATION POLICY:-interest on loan and debentures is deductible item under the income Tax act in India,while dividend is not deductible.to take advantage of this provision companies may be tempted to issue debentures.

12 MANAGERIAL STYLE:-How much to borrow also depend on managers approach to finance risk. conservative managers will usual try to keep the debt equity ratio low.

IMPORTANCE OF CAPITAL STRUCTURE:-Deciding on an appropriate capital structure is critical for any business organization. The decision is important not only due to the need to maximize returns to various organizational constituencies, but also due to the impact such a decision has on an organizations ability to deal with its competitive environment. The prevailing argument, originally developed by Modigliani and Miller (1958) is that an optimal capital structure exists which balances the risk of bankruptcy with the tax savings of debt. Once established, this capital structure should provide greater returns to stockholders than they would receive from an all-equity firm.

Determinants of the firms opitmal capital structure are as follows:

1. The Tax Deductibility of Interest

The tax deductibility feature of interest expense tends to increase the use of debt in the firm's capital structure.

2. Financial Risk

The increased financial risk that comes with increased use of debt tends to moderate the use of debt in the firm's capital structure.