Fundamentals of Financial Management, Third Edition

14.1 THE BASIC ISSUE

Capital structure represents the ratio between different forms of capital. Broadly speaking, there are two types of capital: the owner’s fund or share capital; and the borrowed fund. The borrowed fund is also known as the fixed-cost fund insofar as the amount of interest is fixed. The dividend on preference shares is also fixed but such shares represent the owners’ fund. On the contrary, the dividend on the equity shares is not fixed, and so the equity share capital is not a fixed-cost capital.

Mixing fixed-cost capital with the equity share capital is known as financial leverage. The process is known also as trading on equity as the equity capital forms the basis for raising the borrowed funds.

 

Capital structure represents ...