Capital and Its Structure

There are four key concepts of the term "capital":
• traditional;
• indifference of the structure;
• compromise;
• conflict of interest.
The traditional concept is that capital structure is created by considering the varying cost of individual elements. This means that the price of the own funds attraction is always higher than of borrowed ones. This is due to different levels of risk. The profitability of the borrowed funds has deterministic nature: the rate of interest is determined by the parties at a fixed size. The profitability of personal funds is formed in market conditions based on the results of economic activities.
The security capital structure of an enterprise is secured in the form of guarantees by third persons, a pledge or a mortgage. In case of bankruptcy of an organization, the law of many countries provides the right to meet the claims of creditors (in the first turn). That is, the use of borrowed capital leads to a decrease in the weighted average price of an enterprise resources and increases the market value of an organization. The application of these principles in practice encourages owners to maximize the volume of loans, reduce financial stability.
The concept of indifference of the structure assumes that the optimal capital structure does not depend on the growth in the market value of an organization. However, its return on assets matters. This concept, which was developed by F. Modigliani and M. Miller, is theoretical.
The compromise concept is based on several contradictory conditions that determine the level of profitability and risk, which should be considered in a particular way in the process of the capital structure optimizing:
• Debt-servicing costs are deductible from the tax base¬.
• In case of an increased leverage ratio, an organization is on the verge of bankruptcy.
• The cost of individual elements of the funding sources attracted from outside includes not only the cost of debt servicing, but initial costs too.
Based on the concept of conflict of interest, managers unlike owners receive more complete information on the activity of an organization. Under favorable growth prospects, managers will try to meet the need for finance through borrowing. Otherwise, they will use the capital from external sources, for example, additional shareholders ' investment.
Lenders want to exercise control over the use of funds. These costs are transferred to the owners. The higher the proportion of debt capital is, the higher level of costs, weighted average cost of funds and the market price of a company are. These are the current definitions of the terms "capital" and "capital structure".
The concept "cost of capital" is not less important. Уou can read in detail about the concept "cost of capital": http://financialmanagementpro.com/category/cost-of-capital/.