15 Sep 2022

Understanding Capital Structure – Its Objectives & Theory


Articles - FOB,

Capital structure is very important as it has a major influence on the direct financial position of a company. Its function is regarding the use of capital in running a business and how the development of the business runs. Many factors affect the structure of this capital.

Capital structure plays an integral role in optimizing the performance and quality of a company. The mindset in developing companies and businesses also has a big influence on this structure owned. Therefore, many successful entrepreneurs sometimes have a difficult time running their companies, because it also requires determination and hard work.

Understanding Capital Structure

The capital structure is a set of principal money that is run for the business and financial-related arrangements in running the business from different sources over a long period. This structure relates to a combination of shares, equity, preference share capital, and debt securities to long-term loans.

In addition, there are retained earnings and long-term sources of funds, all of which are collected by the company. This situation requires the company to carry out strict supervision so that the future of its financial condition is maintained for a long time. In addition, there are several definitions of capital structure by several experts.

  • According to Gerstenberg

An expert named Gerstenberg mentions this structure as a process of increasing the capitalization of a company. This includes various resources that can be controlled, including in this case loans, reserves, stocks to bonds.

  • According to John J. Hampton

John J. Hampton defines this structure as a mixed process of effects, arising from the debt. In addition, the condition also occurs because of equity against the financing of a company’s assets.

  • According to I. M. Pandey

A leading expert who argues that the this structure is a combination of various sources of funds in the long term consisting of several elements. Such as debt, preference shares to equity in reserve, or surplus status.

Purpose of Capital Structure

The purpose of the this structure is to mix or collaborate from sources of funds, namely permanent funds and activities from the company’s operational activities, this situation is carried out so that the company can achieve optimal value because this structure can maintain the quality and reliability of the company in economic activities.

Capital Structure Theory

The capital structure requires detailed and systematic knowledge, this arises because of the theory of capital structure. This theory becomes the basis used to run a certain capital structure, but in the process, it becomes more controlled and even balance according to emerging scientific knowledge and has this structure formula.

Examples of The Theory Underlying Capital Structure

  • Traditional Approach Theory

The focus of this theory is on optimal management and mapping because this structure has a very strong influence on firm value. This condition makes the capital structure can be changed and adjusted to get optimal results in a company.

  • Modigliani and Miller’s Approach Theory

This theory proposes three important propositions, first, the capital structure is irrelevant to the value of the company which makes identical company values will remain the same and survive. No effect on finances. Meanwhile, tax information is very important for an increase when knowing the insured tax.

The third is the cost of bankruptcy in the capital structure, assets can be sold at the appropriate price in the market. Earnings before interest or EBIT is not influenced by company debt, therefore the presence of investors is very influential on the importance of price takers.

  • Trade-Off Theory

The view that sees the determination of the capital structure must be optimal, the required factors are agency costs, taxes, and financial difficulties. The result is when the company persists, this theory emphasizes paying attention to market efficiency.

  • Pecking Order Theory

This theory has a point of view where the level of profit obtained by a company is large. This condition makes the company have less debt, this gives rise to several preferences in a coherent manner in this theory. Some of them such as companies opting to choose internal income earnings, and investigative estimates to calculate payout ratios.

  • Information Asymmetry and Signaling Theory

Being the only theory that states that parties and company members do not have the same information on the emergence of risk. This condition conveys two views, from Myers and Majluf who mention differences in information acquisition and signaling in view explain the development of capital.

Factors Affecting Capital Structure

capital structure

  • Asset Structure (Tangibility)

Is a way to fulfill the allocation of funds in each component of assets, both fixed and current. Weston and Brigham, the structure of assets as a balance or comparison appear between fixed assets and total assets. The fulfillment of capital depends on the condition of the assets of a company.

  • Growth Opportunity

It is an opportunity for the company to grow in the future, but some experts call it with different opinions. Growth opportunity is a turning point for changes in the assets of the company because it will tend to make profitable investments on its own.

  • Company Size (Firm Size)

The size of the company greatly influences the company’s capital structure and the activities that arise and then make the development of the capital structure visible from the progress or size of a company. This condition can make the company grow and develop, along with higher achievements.

  • Profitability

Profits or high profits usually have high internal capital, in addition to the allocation of reserve funds. The company in this case has a status far from debt from outside parties, this is what makes the influence of capital structure on this ongoing company.

  • Business Risk

This makes many companies have to be careful, especially about determining capital, and because of the risks that arise, there are obstacles. Finally, it creates a negative influence on the internal funding system, a condition that makes it difficult to determine the type of capital.

Also read: Understanding the Economic Recession – Its Causes and Impacts

Capital Structure Function

  • Return Maximization

The setting of the capital structure greatly affects the increase in share profit, this is a good thing and allows shareholders to get optimal returns. Shareholders can even recover loans and make them avoid debt conditions.

  • Flexibility

Capital can provide a more dynamic movement of debt expansion, although it can be adjusted to the desired strategy and business conditions. This condition allows the company to get a significant movement of progress.

  • Solvency

The company’s liquidity is maintained with a good capital structure, this happens if the company can avoid the burden of interest payments in the event of unplanned debt. Therefore, making the company’s cash disappear.

  • Increase Company Value

Investors are looking for companies that have a good capital structure, investors prefer to invest in companies that have well-maintained capital regulations. When the company can create them, stocks and securities can continue to increase.

  • Reducing Financial Risk

The proportion of finance and equity must be kept in balance, one of which is having a good capital structure. The company then avoids the financial crisis and makes the company stays away from bankruptcy.

  • Minimizing the Cost of Capital

Designed to meet debt capital in the long term is a sweet strategy, often carried out by companies to prepare them for the future. This condition allows the company to minimize the usual borrowing costs required.

  • Tax Planning Tool

The funds taken by the company as debt funds are used as capital, this tends to lead to long-term difficulties when they do not have a good capital structure. Conditions caused by the value of taxes are increasing so that loans continue to appear because of the importance of regulating the capital structure.

  • Optimal Fund Utilization

A good capital structure makes the company more flexible in preparing plans, in a systematic and strategic series. Conditions that make the company, consequently produce optimal output from the resulting profit.

Difference between Capital Structure, Financial Structure and Asset Structure

These three terms are usually interpreted to mean the same thing, although, in reality, they are very different. The capital structure is a balance between debt and equity capital that must be owned by the company. Financial structure is the company’s way of costing assets such as debt, shares, and investment returns.

The financial structure focuses on the net worth of the owner of a company, in addition to the obligations that must be borne. While what is meant by asset structure is said to be a balance or comparison of the entire wealth between fixed and current assets of a company.

This is a brief explanation of the capital structure, ranging from understanding, theory, and influencing factors to the functions provided by the capital structure. An understanding of one of the important components of the business world is explained in more detail in the Sampoerna University journal as an additional reference for students.

Sampoerna University Faculty of Business applies an international curriculum, providing complete world-class facilities for students. Apart from having complete facilities, Sampoerna University also has quality teaching staff. Sampoerna University students are prepared to compete for not only at the national level but also internationally.

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