Case Study-IV

Enron- A Classic corporate Governance Case

(Business & Society)

Submitted By:
Naina Shrestha
BBA VI sec B

Submitted To:
Mr. Rahish Shrestha

CAPITAL STRUCTURE

Concept
Capital structure is essentially concerned with how the firm decides to
divide its cash flows into two broad components, a fixed component that is
earmarked to meet the obligations toward debt capital and a residual
component that belongs to equity shareholders-P. Chandra.
Capital structure is a part of financial structure of an organization and is
defined as the proportion of various long-term financing such as debt and
equity. Long-term debt, preferred stock and net worth provides a
permanent financing to a firm. Equity refers to the capital employed in the
organization by the owners. Bonds, long-term notes payable, working
capital are the forms of debt whereas common stock, preferred stock and
retained earnings are the forms of equity. The proportion or ratio of debt
and equity entirely depends upon the financial policy of organizations.
Thus, capital structure refers to the appropriate proportion of these debts
and equity to form the financial structure of the organization.
Hence, debt to equity ratio (D/E ratio) is used as a measure of comparing
the capital structure.
D/E ratio= Debt/Equity
Importance
Capital structure plays an important role in taking the decisions relating to
financing the assets of a firm. Some of the importances of capital structure
are:
1) Through appropriate proportion of debt and equity, a firm can lower
the overall cost of capital and thus, minimizing the cost of financing of
a firm.
*Overall cost of capital=wd x kdt + ws x ks + we x ke
Where, kd<ks<ke
Thus, debt is less risky than equity.

2) A proper capital structure helps maximize the value or wealth of the

organization by maximizing the aggregate value of the claims and
ownership interests of the shareholders.
3) A proper capital structure of a firm helps to increase the wealth and
minimizes cost and thus increasing the earning per share of the
shareholders. This increased EPS automatically increases the market
price of the companys share. Higher the earning per share of the
firm, higher the dividend is paid to the shareholders of the firm.
4) Capital structure increases a companys opportunity to involve in
wealth-creating investments in future. These investments help in
expansion and growth of the company.
Influencing Factors of Capital Structure
There are many factors which influences the capital structure of a firm.
Some of the factors are:
1)
2)
3)
4)

Expected cash flows

Stability of sales
Control over the company
Types of investors

1) Expected cash flows: The expected cash flows of the firm in future
must be enough to pay the interest and debentures every year and
also to return the maturity amount at the end of maturity period of
debentures. Therefore, a firm must not distribute debenture if it is
likely to have irregular cash flows.
2) Stability of sales: Increased sales enables a company to use more of
debt capital as it can pay the interests of debts. Thus, stability of
sales helps a firm in paying the interest on debentures.
3) Control over the company: A company is controlled by Board of
Directors. To retain the control over the company, BOD does not
allow further equity shares to the public rather funds are raised
through preference shares and debentures.

4) Types of investors: Different types of investors influence the capital

structure of a firm. For example, people likely to take risks are
attracted through equity shares where as people not likely to take risk
in investment are attracted through debentures and preference
shares.
Thus, capital structure can be influenced through various factors. Capital
structure is simply a mixture of long term debt, short term debt, common
equity and preferred equity.
Reference: Investopedia and articles