## Capital Structure – Meaning & Optimum Mix
### What Is Capital Structure?
Capital structure is the combination of capitals from different sources used to finance a company's assets.
It typically includes:
- Equity shareholders' fund
- Preference share capital
- Long-term external debts (loans, debentures)
### Three Design Principles
| Principle | What It Means |
|---|---|
| Control | Existing shareholders should retain majority stake |
| Risk | Financial risk should not exceed a tolerable limit |
| Cost | Overall cost of capital should remain minimum |
### Why Is Debt Called 'Cheaper'?
Three reasons debt is preferred over equity as a source of finance:
1. Tax Benefit – Interest is tax-deductible, reducing taxable income (unlike dividends).
2. No Dilution of Control – Borrowing does not affect ownership; new equity dilutes existing shareholders.
3. Lower Required Return – Creditors accept lower returns because they have priority over shareholders in repayment (lower risk).
### Optimum Capital Structure
The optimum capital structure is the specific mix of debt and equity where:
- The firm's overall cost of capital is minimised, AND
- The value of the firm is maximised.
It balances two opposing forces:
| Debt | Equity |
|---|---|
| Provides tax benefits (interest deduction) | Safer and more flexible |
| Increases financial risk | More expensive (shareholders expect higher returns) |
> Key Insight: The optimum point is where advantages of debt are fully utilised without letting the risk of insolvency outweigh them.