Balanced or Sound 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 or sound capital structure.
Objective And Importance of Sound Capital Structure
The future development and expansion of a corporation depend,
inter alia, upon its well-devised capital structure. The importance of a sound or balanced capital structure is
evident from its following objectives:
1. Minimisation of Cost: The primary objective of a company
is to maximize the shareholders' wealth. In this direction, a
well-devised capital structure enables a company to raise the requisite funds
from various sources at the lowest possible cost in terms of the market rate of interest and expenses
of issue, etc. The minimum average cost of capital maximizes the returns to the
equity shareholders as well as the market value of shares held by them.
2. Maximisation of Return: The primary aim of every
corporation is to promote the shareholder's interests. A balanced capital
structure enables a company to provide maximum return to the equity
shareholders to the company by raising the requisite capital funds at the
minimum cost and by maintaining a suitable ratio of borrowed and owned capital.
3. Minimisation of Risks: A sound capital structure serves as insurance against various business risks, such as-increase in costs,
interest rates, taxes, and reductions in prices. These risks are minimized by
making suitable adjustments in the components of capital structure. A balanced
capital structure also enables the company to meet the business risks by
employing its retained earnings for smooth business operations.
4. Retention of Control: The management of a company is in the hands of
directors. But indirectly, a company is controlled by equity shareholders who
have the right to elect directors. Since preference shares carry limited voting
rights and debentures do not have any voting rights, a well-devised capital
structure ensures the retention of control over the affairs of the company
within the hands of the existing equity shareholders by maintaining a proper
balance between voting rights and non-voting right capital.
5. Adequate Liquidity: One of the objectives of a balanced capital
structure is to maintain proper liquidity which is necessary for the solvency
of the company. A sound capital
structure enables a company to maintain a proper balance between fixed and
liquid assets and avoid the various financial and managerial difficulties of
the company.
6. Full Utilisation: Optimum utilization of the available financial resources is another
important objective of a balanced financial structure. An ideal
financial structure enables the company to make full utilization of available capital by
establishing proper coordination between the quantum of capital and the
financial requirement of the business. Thus, a balanced capital structure helps
a company in eliminating both the states of over-capitalization and
under-capitalization which are harmful to the financial interests of the
company.
7. Other Objectives: In addition to the above, a balanced capital
structure has also the following objectives-
(i) Simplicity: A balanced capital structure is aimed at limiting the number of issues and types of securities, thus, making the capital structure as simple as possible.
(ii) Flexibility: A balanced capital structure is devised in such a way as to make the necessary changes in it according to the changing conditions. The flexibility of capital structure enables the company to raise additional capital at the time of need, or redeem the surplus capital. Thus, the flexibility in capital structure not only helps in fuller utilization of the available capital but also eliminates the two undesirable states of over-capitalisation and under capitalisation.
