Capital Structure

What is Capital Structure?

Capital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.

The owner’s capital is in the form of equity shares (i.e. common stock), preference shares (i.e. preference stock), or any other form which is eligible to take control over the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more of the entity. Debt capital is in the form of the issue of bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more or debentures of loans from a financial banker. Capital structure is a very critical factor in the case of project financingProject FinancingProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. read more. The bankers are much concerned about the initial percentage of funding to the proposed project and usually assist up to 70% of the project cost.

Capital Structure Formula

The formula of capital structure quantifies the amount of equity and the amount of outsiders’ capital at a point in time. We can do such calculations in a simple form, as a percentage of each capital to the total capital or the ratio of debt to equityDebt To EquityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more.

Let us calculate capital structure using Debt/Equity formula

Capital Structure Example 1

A company with a higher debt-equity ratio is said to be a highly leveraged company.

Examples of Capital Structure

You can download this Capital Structure Excel Template here – Capital Structure Excel Template

Example #1

Lets’ say a company has proposed investment in a project with the following information about its project cost. The project will be financed 20% by the common stock, 10% by the preferred stock & the rest by the debt. The company intends to understand its calculations.

Example 1.1

Solution:

Capital Structure Example 1.2
Example 1.3

Debt Equity will be –

Capital Structure Example 1.4

Debt Equity Ratio = (1794/769) = 2.33

Example #2

The capital structure of the entity over the projected years is as follows:

Capital Structure Example 2
Example 2.1

Note: Over the years, the debt-equity share is reducing since the reserves are increasing, and the company is able to repay its debt holders.

Types of Capital Structure

Capital Structure

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For eg:
Source: Capital Structure (wallstreetmojo.com)

#1 – Equity Share Capital

#2 – Debt

#3 – Preference Share Capital

#4 – Vendor Finance

Why is it Important?

Recommended Articles

This article has been a guide to what is capital structure and its meaning. Here we discuss its formula, examples, types and why it is important? You may learn more about financing from the following articles –