Capital structure means the structure or constitution or break-up of the capital employed by a firm. The capital employed consists of both the owners’ capital and the debt capital provided by the lenders. Debt capital is understood here to mean the long term debt which has been deployed to build long term assets. Apart from the elements of equity and debt in the capital structure, a firm could have quasi-equity in the form of convertible debt.
The Financing or Capital Structure decision is a significant managerial decision as it influences the shareholders.
Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital structure.
According to the definitions of Gerstenberg, “Capital Structure of a company refers to the composition or makeup of its capitalization and it includes all long-term capital resources”.
According to the definition of James C. Van Horne, Captial Structure is “The mix of a firm’s permanent longterm financing represented by debt, preferred stock, and common stock equity”.
Type of Capital Structure
The Capital Structure of a firm is a reflection of the overall investment and financing strategy of the firm. It shows how much reliance is being placed by the firm on external sources of finance and how many internal accruals are being used to finance expansions etc. Capital structure can be of various kinds as described below:
1. Horizontal Capital Structure
In a Horizontal capital structure, the firm has zero debt components in the structure mix. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained earning only. The absence of debt results in a lack of financial leverage. The probability of disturbance of the structure is remote.
2. Vertical Capital Structure
In a vertical capital structure, the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the superstructure of preference share capital and debt is built. The incremental addition in the capital structure is almost entirely in the form of debt. Quantum of retained earnings is low and the dividend payout ratio is quite high. In such a structure, the cost of equity capital is usually higher than the cost of debt. The high component of debt in the capital structure increases the financial risk of the firm and renders the structure unstable. The firm, because of the relatively lesser component of equity capital, is vulnerable to hostile takeovers.
3. Pyramid-shaped Capital structure
A pyramid-shaped capital structure has a large proportion consisting of equity capital and retained earnings which have been plowed back into the firm over a considerably large period of time. The cost of share capital and the retained earnings of the firm is usually lower than the cost of debt. This structure is indicative of risk-averse conservative firms.
4. Inverted Pyramid-shaped Capital Structure
Such a capital structure has a small component of equity capital, a reasonable level of retained earnings but an ever-increasing component of debt. All the increases in the capital structure in the recent past have been made through debt only. Chances are that the retained earnings of the firm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable to collapse.