Just as planning and design of a physical structure are important, the same holds true for capital structure as well. A well-thought-out plan for the capital structure supplemented by a careful design ensures that the prime goal of the firm, i.e. maximization of the shareholder wealth is easily achieved.
Planning of the capital structure is a preliminary activity and it might commence as early as the time of incorporation of the firm. Once the firm is established, the next logical step is to move in the direction of the implementation of the project. For meeting the cost of the project, the means of finance are to be arranged. Hence the need for timely and early planning of the capital structure.
The management of a company should seek answers to the following questions while making the decision regarding the capital structure of the company:
- How should the investment project be financed?
- Does the way in which the investment projects are financed matter?
- How does financing affect the shareholders’ risk, return, and value?
- Does there exist an optimum financing mix in terms of the maximum value to the firm’s shareholders?
- Can the optimum financing mix be determined in practice for a company?
- What factors in practice should a company consider in designing its financing policy?
Attributes of a Well Planned Capital Structure
A sound or appropriate capital structure should have the following features:
Return: The capital structure of the company should be most advantageous. Subject to other considerations, it should generate maximum returns to the shareholders without adding additional cost to them.
Risk: The use of excessive debt threatens the solvency of the company. To the point, debt does not add significant risk. It should be sued, otherwise, its use should be avoided.
Flexibility: The capital structure should be flexible. It should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.
Capacity: The capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum.
Control: The capital structure should involve minimal risk of loss of control of the company. The owners of closely-held companies are particularly concerned about the dilution of control.
Designing a Capital Structure
After planning the capital structure, we are faced with the issue of its design. The design takes off from where the plan ends. Planning establishes the broad parameters of the structure. It is left for the design to fill in the minor details. While designing a capital structure, the following points need to be kept in view:
1. Design should be functional: The design should create synergy with the long term strategy of the firm and should not be dysfunctional. It should facilitate the day to day working of the firm rather than create systematic bottlenecks.
2. Design should be flexible: The capital structure should be designed to incorporate a reasonable amount of flexibility in order to allow for temporary expansion or contraction of the share of each component.
3. Design should be conforming statutory guidelines: The design should conform to the statutory guidelines, if any, regarding the proportion and amount of each component. The limits imposed by lenders regarding the minimum level of owners’ equity required in the firm should be complied with.