Does Capital Structure Matter (2024)

The capital structure of the firm, initially made up of debt and equity and thereafter augmented by retained earnings, debt enhancement and infusion of capital, is considered to be one of the most important elements of modern-day economic theory and business activity. Organisational managements take care in designing their capital structure after considering various factors like the organisational need for long-term funds, potential tax savings and the implications of financial risk. The importance of capital structure in modern business has attracted substantial academic, researcher and management practitioner interest and to the development of various theories on the subject. Such theories have not only enriched the area and added to knowledge on the subject but have also attracted extensive debate, discussion and criticism.

Organisational decisions on the quantum of capital structure are influenced by three specific considerations, i.e. the organisational need for long-term financing on account of both ongoing and future businesses, the comparative cost of debt and equity, and the financial risks associated with excessive use of long-term debt. The cost of debt is considered to be lower than the cost of equity because of the deductibility of interest from income for purposes of tax payment. Whilst enhancement in the usage of debt theoretically results in a reduction of organisational costs and adds to post-tax organisational profitability, it also leads to organisational exposure to financial risks. Both debt and the interest thereon have to mandatorily be repaid to debt providers; the failure to do so can result in punitive action from lenders, the takeover of the defaulting organisations, the liquidation of assets and the closure of business activities. An overload of debt can thus result in significantly greater costs and severe consequences for business firms, despite its seeming attractiveness as an economic and effective source of long-term funds.