- Asked 2/26
- 2080 Baisakh · 3 marks
- 2071 Chaitra · 5 marks
Capital structure planning concept
Short answer
Capital structure planning decides the mix of long-term funds (equity, preference, retained earnings, debt) to minimize WACC and maximize firm value and EPS with acceptable risk. Plans are compared by debt-equity ratio; for Rs 10 lakh, Plan B (1:1 debt-equity) balances return and risk. Steps include estimating capital need, comparing mixes by EBIT-EPS, and checking risk, control and flexibility.
Explain capital structure planning (with examples).
Concept
Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.
A firm can finance with ordinary shares, preference shares, retained earnings, debentures and loans. Planning decides the debt-equity ratio so that the weighted average cost of capital (WACC) is minimum and the EPS and value of the firm are maximum, with acceptable risk.
Objectives
- Maximise shareholders' wealth
- Minimise the cost of capital
- Maintain liquidity and flexibility
- Keep control and reduce financial risk
Example
Total capital needed = Rs 10 lakh.
| Plan | Equity | Debt (10%) | Debt-equity |
|---|---|---|---|
| A | Rs 10,00,000 | Nil | 0 : 1 |
| B | Rs 5,00,000 | Rs 5,00,000 | 1 : 1 |
| C | Rs 3,00,000 | Rs 7,00,000 | 2.33 : 1 |
Plan A is safest but gives low EPS; plan C has high EPS if profits are good but high risk when profit falls. The planner selects the plan which balances return and risk, for example plan B, by using the determinants such as cash flowability, cost, control and flexibility.
Steps
- Estimate the total capital requirement.
- Find the available sources and their costs.
- Compare different mixes by EPS-EBIT analysis and cost of capital.
- Check risk, control, flexibility and legal limits.
- Select the optimal capital structure and review it from time to time.
✓ Answer checked by Claude Opus 5.5 (high effort)
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