Capital Structure in Finance plays an important role. The concept of Capital Structure defines the percent of equity and debt in long term liabilities in the balance sheet. To support its investments, a firm or a company must find the means to finance them. Equity and debt represent the two broad sources of finance for a business firm. Equity consists of equity capital, retained earnings and preference capital. Debt consists of term loans, debentures and short-term borrowings.
Some of the types of long-term finance options that are available are:
Equity Capital: Equity Capital is one of the basic types of finance. Equity capital is issued in the primary market to general public. The general public will buy the shares and will contribute to the equity capital. These shares can be sold by the owners in the secondary market or a stock exchange. Equity shareholders are the rightful owners of the company.
Internal Accruals: Internal Accruals of a firm consist of depreciation charges and retained earnings. Depreciation represents the allocation of capital expenditure to various periods over which the capital expenditure is expected to benefit the firm. Retained earnings are that portion of equity earnings (profit after tax less preference dividends) which are ploughed back in the firm. Nearly 30 to 80 percent of profit after tax is retained for financing growth.
Preference Capital: Preference Capital represents a hybrid form of financing – it partakes some characteristics of equity and some attributes of debentures. It resembles equity in the following ways: Preference dividend is payable only out of distributable profits. Preference dividend is not an obligatory payment. Preference dividend is not a tax-deductable payment.
Preference capital is similar to debentures in several ways. The dividend rate of preference capital is fixed. The claim of preference shareholders is prior to the claim of equity shareholders. Preference shareholders do not normally enjoy the right to vote.
Term Loans: Term loans come under the category of long-term debt. Firms obtain loans given by financial institutions and banks have been the primary source of long-term debt for private firms and most public firms. Term loans are also referred to as term finance, represent a source of debt finance which is generally repayable in less than 10 years. Long term finance is used to acquire fixed assets such as machinery, buildings, etc.
Debentures: Debentures are an alternative to term loans. Debentures act like negotiable instruments in one way. Debenture holders are the creditors for the company. The company is the debtor for the debenture holders. There is an obligation for the company to pay Interest every year to these debenture holders. The amount of interest is limited and the time period for the debentures to mature is also limited.
The key differences between equity and debt are:
- Debt investors are entitled to a contractual set of cash flows, where as equity investors have a claim on the residual cash flows of the firm, after it has satisfied all other claims and liabilities.
- Interest paid to debt investors represents a tax-deductible expense, whereas dividend paid to equity investors has to come out of profit after tax.
- Debt has a fixed maturity, whereas equity ordinarily has an infinite life.
- Equity investors enjoy the prerogative to control the affairs of the firm, where as debt investors play a passive role – of course, they often impose certain restrictions on the way the firm is run to protect their interests.
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