The meaning of Capital structure can be described as the arrangement of capital by using different sources of long-term funds which consists of two broad types, equity and debt. The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans etc. These funds are raised for running the business.

 Capital structure refers to the specific mix of debt and equity used to finance a company's assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility. Financial flexibility allows a company to raise capital on reasonable terms when capital is needed. Conversely, debt represents a cheaper, finite-to-maturity capital source that legally obligates a company to make promised cash outflows on a fixed schedule with the need to refinance at some future date at an unknown cost.

As we will show, debt is an important component in the "optimal" capital structure. The trade-off theory of capital structure tells us that managers should seek an optimal mix of equity and debt that minimizes the firm's weighted average cost of capital, which in turn maximizes company value. That optimal capital structure represents a trade-off between the cost-effectiveness of borrowing relative to the higher cost of equity and the costs of financial distress.

In reality, many practical considerations affect capital structure and the use of leverage by companies, leading to wide variation in capital structures even among otherwise-similar companies. Practical considerations affecting capital structure include the following: business characteristics: features associated with a company's business model, operations, or maturity; capital structure policies and leverage targets: guidelines set by management and the board that seek to establish sensible borrowing limits for the company based on the company's risk appetite and ability to support debt; and market conditions: current share price levels and market interest rates for a company's debt.

 The prevalence of low interest rates increases the debt-carrying capacity of businesses and the use of debt by companies. Because we are considering how a company minimizes its overall cost of capital, the focus is on the market values of debt and equity. Therefore, capital structure is also affected by changes in the market value of a company's securities over time.

Financing arrangements determine how the value of the company is shared up. The persons or institutions that can buy debt from the company are called creditors and holders of equity are called shareholders.

We tend to think of capital structure as the result of a conscious decision by management, but it is not that simple. For example, unmanageable debt, or financial distress, can arise because a company's capital structure policy was too aggressive, but it also can occur because operating results or prospects deteriorate unexpectedly.

Finally, in seeking to maximize shareholder value, company management may make capital structure decisions that are not in the interests of other stakeholders, such as debtholders, suppliers, customers, or employees.

A good capital structure provides firms with the flexibility of increasing or decreasing the debt capital as per the situation it also helps maximizing shareholder's capital while minimizing the overall cost of the capital.

 

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