What is the importance of capital structure?

The capital structure decisions are very important in financial management. These decisions influence debt-equity mix which ultimately affects shareholders.’ return and risk. Since the cost of debt is cheaper, companies prefer to borrow. The value of equity depends upon earnings per share. As long as return on investment is more than the cost of borrowings, extra borrowings will increase the earnings per share. However, beyond the limit, it increases the risk and the share price may fall. The effect of fall in share price due to heavy load of debt is difficult to measure. Market factors are so highly psychological and complex as they hardly follow these theoretical considerations. However, a company can determine an appropriate debt-equity mix empirically, considering various factors.

The debt-equity mix in the capital structure is one of the important factors. Affecting the value of a share of a company. There is a significant relationship between the share price and the variables like return, risk, growth size and leverage. Companies in India are now showing almost an equal preference for debt and equity in designing their capital structure. This is due to the freedom in paying dividend and easy to raise money. However, the returns have become uncertain due to increasing competition.

An important function of financial management is to decide an appropriate capital structure of their company. The financial performance of a company depends upon the capital structure decisions. A good capital structure will help the company to increase profits, efficiency and reputation of the company. Therefore, capital structure decisions are very important.