What is Capital Sructure? 

The capital structure is a mix of debt and equity, that a firm uses for funding its different activities and investments. Companies weigh factors such as cost of debt in comparison with cost of equity to balance the level of risk, and to assess the returns for shareholder profits.

When a firm takes on debt, it can decrease its cost of capital because interest payments are tax deductible, but that does increase the financial risk of the company as the firm is responsible to repay the principal amount with interest.

Whereas equity financing eliminates a firm’s debt obligations, but it dilutes ownership and thus potentially decreases returns for existing shareholders.

The optimal capital structure strikes a balance between giving the firm all the means to grow efficiently without simultaneously diluting any risks.

High growth firms may have more equity because flexibility is their primary concern, and established firms may use more debt due to leverage of tax benefits.

Investors take into account a company’s capital structure as a way to overview a firm’s financial strategy, risk profile, and the possible future profitability of that firm.

Capital structure is also important in maintaining the financial health and long-term visibility of a firm. A well-structured capital increases the stability of the firm as well as its market value because it increases the price of its shares and securities, thus increasing the market valuation value of the firm.

It ensures efficient utilization of funds, avoiding over or under capitalization, minimizes the cost of capital while attempting to maximize shareholder wealth and maximizes profitability through higher returns to the stakeholders by giving greater flexibility in adjusting debt levels according to business needs.

Significance of Capital Structure in Fundraising

Capital structure is important in fundraising because the finance mix of debt and equity directly determines a company’s financial health and risk profile, and its ability to attract many investors and creditors.

The entire debt and equity structure gets viewed by investors and creditors to understand the risk or profit the investment will bring. One of the main ways through which investors perceive capital structure is through debt-to-equity ratio which calculates the amount of debt held by a company in comparison to its equity. A high D/E ratio means that the company is really indebted.

Even though a high D/E ratio increases the potential return of a company from its financing perspective, it increases the risk of the company. For example, D/E ratio can be more or less higher in transportation industries because of the very nature of the business that is capital-intensive; whereas service companies could typically have a lower D/E ratio. 

Investors focus on the D/E ratio because it examines how likely default would occur in the company. Companies that have too much debt may have problems raising funds because lenders might feel that they have a greater risk of facing a default situation. Whereas, too little debt may be a signal that a company does not fully maximize its assets in creating growth, which is also bad for equity investors who are looking for growth.

Therefore there should be an appropriate balance of debt and equity so as to minimize the cost of capital. Debt is cheaper than equity since interest payment is tax-deductible. Moreover, in case of liquidation, debtors rank ahead of equities. Excessive debt makes default likelihood higher and refinancing in the future becomes extremely difficult.

Whereas equity financing dilutes ownership and moderates control to its owners but it is not financial liabilities like debt.

Thus, investors want companies whose capital structure maximizes risk and return in the sense that both debt and equity are flexible in financial management.

Balanced capital structure provides growth opportunities to a firm and also reduces default risk while keeping open access for future funding.

The capital structure is therefore essential to determine how capable a company is to raise funds by minimizing the cost of capital and thus generating financial flexibility in raising funds.

Investors always check the debt-to-equity ratio of the company in order to get its risk profile and potential returns.

The better the balance between debt and equity that a firm’s capital structure has, the more likely it is to appeal to investors both in debt and equity; that the capability of the firm for raising funds to promote its future growth would increase.