Capital Structure: Definition, Theory, Examples of Theory, and Factors

Capital Structure Definition, Theory, Examples of Theory, and Factors

Nikereact.org – Have you ever imagined being a successful entrepreneur who owns many big companies? Wow, it would be nice if that happened. However, it’s not that easy to have a big company, of course, it requires determination and hard work.

One of them is to have a mindset in developing the business itself. Now, regarding business development, it turns out that a company needs a good and targeted capital structure.

This is because the capital structure plays an important role in optimizing the performance and quality of the company. So what exactly is meant by a capital structure?

Understanding Capital Structure

Capital Structure Definition, Theory, Examples of Theory, and Factors

Modal structure is a combination of words from “structure” and “modal”. The term “structure” itself is defined as a more detailed arrangement of each part. While the word “capital” is a collection of principal money to run a business. Therefore, the capital structure has the meaning of setting the principal money in running a business from different sources for the long term of the company.

From the explanation above, we can conclude that the capital structure or “capital structure” is related to a combination of equity shares, preferred share capital, debt securities, long-term loans, retained earnings, and other long-term sources of funds that have been collected by the company. This is what makes the company carry out strict supervision regarding the future financial condition of the company. In addition to the explanation above, several experts have defined the capital structure clearly. The following is the definition of capital structure according to experts:

1. According to Gerstenberg

Gerstenberg defines capital structure as a process of increasing the capitalization of a company that includes various resources and resources that can be controlled, such as loans, reserves, stocks, and bonds.

2. According to John J. Hampton

Hamptron defines capital structure as a mixed process of an impact caused by debt and equity on the financing of company assets.

3. According to I. M. Pandey

Pandey is a leading financial expert who has proven his performance. It also provides an understanding of the capital structure. For him, the capital structure is a mixture of long-term funding sources consisting of debt, preference shares, and equity, both reserves and surpluses.

Thus, we can know that the capital structure is a balance and collaboration between own capital and foreign capital owned by a company. Own capital in question is a form of ownership. While foreign capital is short-term and long-term debt.

Purpose of Capital Structure

The existence of a capital structure has the aim of collaborating sources of funds, both permanent and activities in the company’s operational activities. This is done so that the company achieves optimal value. More than that, the capital structure can maintain the quality and profitability of a company in carrying out its activities.

Capital Structure Theory

Of course, to explore further related to capital structure requires a detailed and systematic knowledge. This is also known as the theory of capital structure. Capital structure theory is the basis used to run a certain capital structure, so that the process is controlled and balanced according to existing scientific knowledge.

Examples of The Theory Underlying Capital Structure
There are five theories that underlie the implemented capital structure. Some of these theories were put forward by well-known financial experts. In addition, these theories are very appropriate to be used by companies. Here is the explanation:

1. Traditional Approach Theory

This theory focuses on optimal management as well as mapping. Therefore, the capital structure is seen as having a strong influence on firm value. This is what causes the capital structure to be changed and adjusted to get optimal results in a company.

2. Modigliani and Miller’s Approach Theory

As the name implies, this theory was coined by Franco Modigliani and Merton Miller. Both have the same view when discussing the issue of capital. Modiglani and Miller’s theory proposes three important propositions, namely:

  • Capital structure is not relevant to firm value. As a result, the value of identical companies will remain the same or survive, while not having an effect on the finances adopted to finance assets. While the value of the company depends on the income expected in the future, starting when there is no tax.
  • It is important to have tax information. This is because the use of assets and sources of funds will increase when knowing the insured tax. In addition, tax information is also needed to determine the reduction of the company’s average weighted cost of capital.
  • There are no bankruptcy costs in the capital structure. In other words, assets can be sold at market prices and earning before interest (EBIT) is not affected by company debt. Therefore, investors play an important role in becoming price takers.

3. Trade Off Theory

The trade off theory has the view that to determine the optimal capital structure, several factors are needed, such as agency costs, taxes, and financial difficulties. However, in order for companies to survive, this theory also emphasizes paying attention to the assumptions of market efficiency. Therefore, business actors will think about the difficulty of costs and how to save taxes.

4. Pecking Order Theory

The pecking order theory has the point of view that the level of profit that can be owned by a company is large, then this will make the company less debt. This is what then emerges several preferences in a coherent manner in the pecking order theory. Here is the explanation:

  1. The company can choose internal income from the company’s operating profit.
  2. The investment forecast can be used to calculate the target payout ratio.
  3. Companies will have cash flows that are greater than expenses when they have a constant policy of fluctuations and investment opportunities.
  4. If there are external conditions, the company will issue the safest securities first.

5. Information Asymmetry Theory and Signaling

This capital structure theory is the only theory which states that members and parties within the company do not have the same information on the occurrence of risk. There are two views expressed in this theory. Here’s the explanation below:

  • Myers and Majluf stated that there are differences in information acquisition between managers and outsiders. Where managers have more complete information about the company than outsiders. Therefore, the main axis in the company is the manager.
  • Signaling is a view that explains that the development of capital that occurs due to debt is a signal that managers send to the market. This happens because managers try to make sure the company has good prospects. In other words, the increase in shares and investor opportunities are wide open.

Factors Affecting Capital Structure

In its journey towards optimizing the company, the capital structure is influenced by several things called determinants. Some of these factors have a high influence on the increase or decrease in capital structure. Here’s the explanation below:

1. Asset Structure (Tangibility)

An economist, Syamsudin stated that the structure of assets or tangibility is a form of fulfilling the allocation of funds for each component of assets, both fixed and current. Another meaning is conveyed by Weston and Brigham, where the asset structure is also referred to as a balance or comparison that occurs between fixed assets and total assets. In other words, the fulfillment of capital depends on the condition of the assets of a company.

When a company invests capital in the form of fixed assets, the fulfillment of capital comes from its own ownership so that debt is only a complement. Meanwhile, companies with larger current assets will tend to choose debt as the fulfillment of funds. From these two examples we can conclude that assets are very influential on the company’s capital structure.

2. Growth Opportunity

The meaning of growth opportunity is an opportunity the company has to grow in the future. However, some experts express a different opinion. Where growth opportunity is a turning point for changes in the company’s assets. Therefore, companies will tend to invest for their own benefit.

3. Company Size (Form Size)

The size of the company greatly affects the capital structure. This is because the activities that can be carried out to develop the capital structure can be seen from the progress or size of a company. In other words, how the company grows and develops in a higher achievement.

The difference can be seen from the ability of the company itself. For example, large companies will find it easier to determine as much profit as possible with a variety of products, besides that they will be better prepared to face crises. While small companies are vulnerable to bankruptcy if they do this.

4. Profitability

Companies with high profits or profits usually have high internal funds, as well as the allocation of reserve funds. This means that the company is far from debt to outsiders. This then affects the capital structure of the company.

5. Business Risk

The existence of business risk, many companies will be more careful in determining capital. This is because the risks that arise can hinder progress and have a negative effect on the internal funding system. In addition, external funding will also experience obstacles so that it is not easy for companies to determine their capital.

From the several factors above, does  understand enough about capital structure? Of course, by understanding these factors, we will know better how the capital structure can work well. Well, then we will discuss the function of the capital structure.

Capital Structure Function

A good capital structure affects the financial position of the business and the company’s management tends to increase. In addition, it will also meet the financial requirements that must be achieved by large companies. Following are the functions of implementing a good capital structure:

1. Return Maximization

The increase in earnings on shares can be increased by managing a good capital structure. This allows shareholders to get optimal returns. In addition, shareholders can recover loans and avoid debt.

2. Flexibility

The capital structure can also provide a more dynamic movement of debt expansion. This can be adjusted to the desired strategy and business conditions. Then the company will get a significant progress movement.

3. Solvency

The company’s liquidity will be maintained with a good capital structure. This can happen because the company can avoid the burden of paying interest on unplanned debt. This is what causes cash on hand to decline.

4. Increase Company Value

Investors look for companies that have a good capital structure. In other words, investors prefer to invest their money only in companies with a well-maintained capital system. If the company is able to create this, then surely the company’s shares and securities will increase.

5. Reducing Financial Risk

The balance between the proportion of debt and equity can be done by having a good capital structure. Therefore, the company will avoid a financial crisis and far from bankruptcy. In addition, the company will have a sound financial condition.

6. Minimize Cost of Capital

The capital structure can also be designed to meet strategic long-term debt capital. This is often done by companies in order to prepare their company for the future. So the company will be able to minimize the required borrowing costs.

7. Tax Planning Tools

Companies that take debt funds as their capital, tend to experience difficulties in the long term when they do not have a good capital structure. This is because the value of taxes will increase and loans will continue to rotate. Therefore, it is important to manage the capital structure.

8. Optimal Use of Funds

Companies that have a good capital structure will be more flexible in preparing plans systematically and strategically. As a result, the company will produce optimal output from the available profit. In addition, the capital structure will also keep the company on track on its way.

Differences in Capital Structure, Financial Structure and Asset Structure

The three terms are often interpreted as the same hall. However, did Nikereact.org know that the three have different meanings? Yep, these three terms have different meanings even though they are both in the economic field.

As we have seen above that the capital structure is a balance of debt and equity capital owned by the company. While the financial structure is the company’s way of financing its assets. For example with debt, stocks, and investment returns.

In other words, the financial structure focuses on the net worth of the owners of the company as well as the obligations that must be borne. While the asset structure is a balance or comparison of all assets between fixed and current assets of a company.

Conclusion

after studying the material on capital structure, he certainly understands more about how companies manage their funds. Well, from the whole explanation above, we can understand the capital structure as a comparison that occurs in retained capital with equity capital ownership, both short and long term. The purpose of the capital structure itself is to combine permanent and current sources of funds for the company’s operations.

This can be realized if the company has a good capital structure management. Financial conditions both internally and externally will be maintained safely so that the company will avoid bankruptcy. Financially maintained will also avoid debt or external loans.

The hope is that companies can make significant progress financially by understanding the capital structure well. In addition, companies with good capital structures are sought after by investors who want to invest their money. This is what makes the company able to survive in the midst of competitive conditions.

Leave a Reply

Your email address will not be published.