Policies of Capital Structure with Diagram

Policies of Capital Structure

All companies have their own policies of capital structure. Capital structure is a mix or combination of debt and equity. The debt-equity ratio is maintained at various levels.

The information content of dividend and capital structure policies are given in the diagram below.

Image credits © Manoj Patil.

Relevance of capital structure are

1. No Debt Policy
2. Limited Debt Policy
3. Debt-Equity Ratio 1:1 Policy
4. Debt-Equity Ratio 2:1 Policy
5. Maximum Possible Debt Policy

Policies of capital structure are follows:

1. No Debt Policy

In policies of capital structure, some firms adopt zero debt policy. The entire capital is raised by Shareholder's funds. Such firms have large retained earnings, and they expand with the help of retained earnings. Some firms do not want to expand their business as they are happy with their present size. So, they use 'Stability Strategy'. If they ever need more funds, they do disinvestment. They sell part of their business to raise funds and do not borrow from outside.

2. Limited Debt Policy

In policies of capital structure, some firms use a limited debt policy. They borrow very least from outside. The debt-equity ratio is less than 1:1. They are similar to No debt policy. They may have retained earnings, which are used for expansion and modernization. Such firms opt, for restricted growth strategy, and thus they may require limited additional funds for expansion.

3. Debt-Equity Ratio 1:1 Policy

In policies of capital structure, firms which try to avoid the high-interest burden may adopt debt-equity ratio 1:1 policy of capital structure. For expansion such firms may use retained earnings or may issue additional shares.Firms which adopt moderate growth strategy may adopt this policy. The firms may resort to debt only to the extent of shareholder's equity.

4. Debt-Equity Ratio 2:1 Policy

In policies of capital structure, many firms adopt this policy. In this policy, the firms borrow 2 times as that of equity capital. For expansion, such firms borrow more funds by way of loans. They do not raise more funds from shareholders. Firms adopting this policy may choose internal and external growth strategies.

5. Maximum Possible Debt Policy

In policies of capital structure, the debt-equity ratio is more than 2:1. Small medium enterprises are allowed debt-equity ratio of greater than 2:1. E.g.:Under composite Loan Scheme for small industries the debt-equity ratio can be 3:1. This policy is not adopted by large firms.