Balanced or optimal capital structure



Balanced or optimum capital structure refers to an ideal combination of various sources of long-term funds in such a way as to minimize the overall cost of capital and maximize the market value per share. The optimum capital structure could only be achieved when the marginal cost of each source of finance is the same. However, it is incorrect to form an opinion that there exists an ideal mix of debt and equity capital that will produce an optimum capital structure leading to the maximization of market price per share. In real life, there is no single optimal capital structure for all firms, or for the same firm at all times. The capital structure differs from firm to firm and for the same firm from time to time depending upon a multitude of factors. The financial manager should, therefore, attempt to develop an appropriate capital structure for his firm instead of trying for a utopian 'optimal capital structure.



The financial manager should attempt to develop a sound capital structure that is in the best interest of the shareholders and the company.   It is generally agreed that an appropriate capital structure is one that can maximize the market price per share in the long run. A sound capital structure should possess the following qualities:

 1. Simplicity:   A sound capital structure is one that is kept simple in the initial stage by limiting the number of issues and types of securities. If the capital structure is complicated from the very beginning by issuing different types of securities, the investors hesitate to venture their investments in such a company and the company may also face difficulties in raising additional capital in the future. Thus, in developing an optimum capital structure, it is advisable to issue equity and preference shares only. Debentures and bonds should be reserved for future financial requirements of the company.


2. Minimum Cost: A sound capital structure should attempt to establish the security mix in such a   way as to raise the requisite funds at the lowest possible cost. The management should also aim at keeping the expenses of issuing fixed annual payments at a minimum to maximize the return to equity shareholders.


 3. Maximum Return: A balanced capital structure should be devised in such a way as to maximize the profits of the corporation. With a view to maximization of return on investments, the company should follow a proper policy of trading on equity so as to minimize the cost of capital.

4. Minimum Risk:  An ideal capital structure should also possess the quality of minimum risk. Business involves various risks, such as increases in taxes, rates of interest, costs, decreases in prices and natural calamities, etc., all of which adversely affect the company's earnings. Thus, the corporation's capital structure should be devised in such a way as to enable it to afford the burden of these risks easily.


5. Maximum Control: A sound capital structure has also the quality of retaining the control of the existing shareholders on the affairs of the company. Generally, the ultimate control of a company rests with the equity shareholders who have the right to elect directors. Thus, while deciding the issue of securities due consideration needs to be given to the question of control in management. If a large number of equity shares are issued, the existing shareholders may not be able to retain control. They should, therefore, issue preference shares or company debentures to the public instead of equity shares because preference shares carry limited voting rights and debentures do not have any voting rights.


6. Flexibility:  An optimal capital should also have the quality of flexibility in it. A flexible capital structure enables the company to make the necessary changes in it according to the changing conditions. In other words, under a flexible capital structure, it is possible to procure more capital whenever required or redeem the surplus capital.


7. Proper Liquidity: Liquidity is necessary for the solvency of a corporation. All such debts should, therefore, be avoided which threatens the solvency of the company. To ensure liquidity, investment in fixed assets and permanent working capital should be made utilizing long-term sources and similarly, the investment in fluctuating working capital should be made out of short-term sources.


8. Conservatism: A company should follow the policy of conservatism in dividing the capital structure. This would help in maintaining the debt capacity of the company even in unfavorable circumstances.


9. Full Utilization: A balanced capital structure is necessary for the optimum structure of a company. Both under-capitalization and over-capitalization are injurious to the financial interest company. Thus, there should be proper coordination between the quantum of capital and the financial needs of the corporation. Fair capitalization enables a company to make full utilization of the available capital at minimum cost.


10. Balanced Leverage: A sound capital structure should attempt of secure balanced leverage by issuing both types of securities, i.e., ownership securities and creditorship securities. Normally, shares are issued when the rate of capitalization is high, and debentures are issued when the rate of interest is low.

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