## Capital Structure: Meaning and Optimum Mix
### What is Capital Structure?
Capital structure is the combination of funds raised from different long-term sources to finance a company's assets.
Components of capital:
- Equity shareholders' fund (ordinary shares + reserves)
- Preference share capital
- Long-term external debts (debentures, term loans)
> Note: Capital structure deals with long-term financing only. Short-term borrowings are part of financial structure but not capital structure.
### Three Governing Principles When Deciding Capital Structure
| Principle | Objective |
|---|---|
| Control | Existing shareholders should retain majority stake |
| Risk | Financial risk must not exceed a tolerable limit |
| Cost | Overall (weighted average) cost of capital should be minimised |
### Optimum Capital Structure
The optimum capital structure is that specific debt-equity mix at which:
- The overall cost of capital (WACC) is minimum, AND
- The value of the firm is maximum.
#### The Balancing Act
```
Debt Equity
───────────────────────────────────────
+ Tax benefit on interest + No fixed repayment obligation
+ Cheaper required return + No bankruptcy risk
− Increases financial risk − Expensive (higher required return)
− Risk of insolvency − Dilutes control
```
The optimum point is where the advantages of using debt are fully exploited without allowing the risk of financial distress to dominate.
### Key Insight
There is no single universal optimum — it varies by industry, company size, stability of earnings, and tax position. The optimum is a range, not a precise number.