Background of the Project

Background of the Project

Every business firm or Bank requires the initial funds for its sound operation. Capital is the blood of the business. A business firm or enterprises cannot run their business without capital. Enterprises whether they are government owned or privately owned have to make pertinent capital structure decision in identifying exactly how much capital is needed to run their operation smoothly.

The fund required are generated usually by two means: equity and debt. Equity provides the ownership of the firm to the shareholders. On the other hand, debt is a fund borrowed with fixed charges to be paid periodically to the debtor. The term capital structure refers to the proportion of debt and equity capital or the composition of long-term sources of finance, such as preference capital, debentures, long-term debt and equity capital including services and surpluses (i.e. retained earnings) and excluding short-term debts.

The term capital structure refers to the mix of different types of funds a company uses to finance its activities. Capital structure varies greatly from one company to another. For example, some companies are financed mainly by shareholders funds whereas others make much greater use of borrowings.

Firstly, we must decide what we mean by a good capital structure. This would be a capital structure, which results in a low overall cost of capital for the company. that is, a low overall rate of return that needs to be paid on funds provided. If the cost of capital is low, then the discounted value of future cash flows generated by the company is high, resulting in a high overall company value. The objective is therefore to find the capital structure that gives the lowest overall cost of capital and, consequently, the highest company value.

The capital structure decision affects the total value of the firm. The proper balance between debt and equity is necessary to ensure a trade off  between risk and return to the shareholders. The capital structure of the bank should be such that leads to the value maximization. The optimal capital structure, i.e. the capital structure with reasonable proportion of debt and equity, minimizes the opportunity cost of capital and maximizes the shareholders’ wealth.