Capital Structure is an integral part of corporate finance and business and finance in general. It is basically a culmination of a number of external funds that is cumulatively known as capital. The capital structure finds its position in the balance sheet of a company which is an indispensable component of the final accounting system of the company. The components of the capital structure include debts, preferred stocks and equity of shareholders or stockholders. The amount of debt in the capital structure is inversely proportional to the financial flexibility of a company, in other words, the greater the debt in the company the greater the financial leverage of the firm. Leverage is referred to as a particular technique that is said to use debt instead of fresh equity in the process of purchasing an asset. A high amount of leverage also reflects significantly in the cost of capital, this is a serious concern for the investors of the company since the increase in the cost of capital means the increase in the cost of funds of the company. The management of the company has to bear the load of maintaining the perfect balance so that the firm can make the best use of the financial leverage as well as keep the cost of capital under control. The capital structure plays an extremely important role in determining the rates which are charged from the customers of the company in return for the purchase of a product or service which is presented by the firm. This process is more commonly known as utility rate-making.
The concept of Optimal Capital Structure is used to portray an ideal situation in the case of a capital structure. This concept states that it is important for an effective management system to identify the risks which are complementary with debts being consistently uprising in the capital structure of a company and it is entirely necessary for the management to maintain a healthy balance between debt and equity which should essentially be more inclined towards equity. This concept clearly states that it is the management’s responsibility to minimise the debts and maximise equity on the frontier of the company. Decisions regarding the capital structure of the company along with the debt ratios of the company should be tempered by the idea of how outsiders contemplate the financial position and stability of the firm in the market as a whole. The main consideration that a company should be undertaking to achieve this result are to maintain a considerably positive credit score or rating, this will help in attracting new funds to the company in the form of investors with good and viable terms. The second point that should be maintained is the maintenance of a good earning record with consistent growth in revenue that can be clearly stated through final accounting along with a stable dividend policy.
The concept of leverage states that till a certain point debt is not considered to be full-fledged liabilities, these debts are in the form of bank loans and well as bonds, in fact, it allows the company to achieve higher earnings compared to issuing equity. The reason behind this being the interest that is paid by the company is lightly imposed with tax and this results in the attraction of investors through the flow of operating income. The increase in revenue per share for relation is called financial leverage. It is only profitable when the company is growing upwards and expanding exponentially.
The concept of seniority in the case of a capital structure comes into play when the company is experiencing bankruptcy. The term fanatical seniority means the sequence of repayment in a situation where the company is facing a sale due to bankruptcy. Typically, the assets of the company are given a rank from most senior to the junior-most and that determines the sequence of theory sale. The senior-most assets must be sold first. There are 4 categories in this case:
- Senior debt (Mortgage bonds that are secured by pledged properties)
- Junior debt or subordinated debt (debenture bonds that are dependent on credit that is general)
- Preferred stock (entitled stockholders)
- Equity (Common stock)
1. What is Capital Structure?
- A balance between the assets and liabilities of the firm
- A balance between the revenue and expenditure of the firm
- A distribution of equity and debt that structures the finances of the company.
- All of the above
Answer: C (A distribution of equity and debt that structures the finances of the company)
2. What are the components of capital structure?
- Debts and Equity
- Debts, Preferred stock and Equity
- Debts, revenue and equity
- All of the above
Answer: B (Debts, preferred stocks and equity)
3. The official term for ‘setting rates’ is
- Price determination
- Selling Price
- Utility Ratemaking
- None of the above
Answer: C (Utility Ratemaking)
4. Which of these is a theory of capital structure?
- Net Income
- Modigliani-Miller Theorem
- Net Operating Income
- All of the Above
Answer: D (All of the above)
5. The Modigliani-Miller theorem is disregarded by economists because
- It is outdated
- It is unrealistic and euphoric
- It has been conclusively proven wrong
- All of the above
Answer: B (it is unrealistic and euphoric)
6. Which of the following statements are true?
- The concept of Optimal Capital Structure is used to portray an ideal situation in the case of a capital structure
- The concept of Optimal Capital Structure says that it is important for an effective management system to identify the risks which are complementary with debts being consistently uprising in the capital structure of a company.
- The concept of Optimal Capital Structure says that it is entirely necessary for the management to maintain a healthy balance between debt and equity which should essentially be more inclined towards equity.
- All of the above
Answer: D (All of the above)
7. Financial Leverage means
- Increase in total earnings per share in the company
- Maximising equity
- Minimising debts
- The balance between equity and debt
Answer: A (Increase in total earnings per share in the company)
8. How can Optimal capital structure be maintained?
- Increase in the credit rating of the firm
- A good record of revenue
- A stable dividend policy
- All of the above
Answer: 8 (All of the above)
9. What is financial seniority?
- A term used for old debts
- The sequence of repayment in case of bankruptcy.
- All of the above
- None of the above
Answer: B (The sequence of repayment in case of bankruptcy)
10: The number of components financial seniority has are:
- 2
- 5
- 7
- 4
Answer: D (4)
11. When is financial leverage profitable?
- When debts are lesser than equity
- When debts and equity are in balance
- When the company is growing exponentially
- When the cost of capital decreases
Answer: C (When the company is growing exponentially)
12. What is the cost of capital?
- Cost of the company funds
- Cumulative calculation of the capital structure
- Cost of capital investment in the company
- Cost of the products or services of the company
Answer: A (Cost of the company funds)
13. Capital Structure is mentioned in the company’s
- Trading account
- Profit and Loss Account
- Balance sheet
- Profit and loss appropriate account
Answer: C (Balance sheet)
14. In financial seniority, ‘senior debt’ refers to:
- Mortgage bonds
- Common stock
- Debenture bonds
- All of the above
Answer: A (Mortgage Bonds)
15. What is leverage?
- The concept of leverage states that till a certain point debt is not considered to be full-fledged liability.
- Leverage is referred to as a particular technique that is said to use debt instead of fresh equity in the process of purchasing an asset.
- Leverage is the increase in revenue per share for relation.
- Leverage is used to portray an ideal situation in the case of a capital structure
Answer: B (A leverage is referred to as a particular technique that is said to use debt instead of fresh equity in the process of purchasing an asset)
