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Capital structure is a fundamental concept in corporate finance and is a frequently tested topic in UGC NET Paper 2 Commerce. Grasping this topic not only enhances your theoretical knowledge but also improves your practical understanding of how businesses are financed and managed. This blog breaks down the essential aspects of capital structure to help you prepare effectively.

What is Capital Structure?

Capital structure refers to the mix of different sources of long-term funds used by a company to finance its operations and growth. These typically include:

• Equity Capital (including share capital and retained earnings)
• Debt Capital (such as debentures, bonds, and long-term loans)
• Preference Capital (a hybrid form between debt and equity)

The combination of these components determines how a company finances its overall operations and investments.

Importance of Capital Structure

A well-planned capital structure helps in:

• Maximizing shareholder wealth
• Reducing the cost of capital
• Improving financial flexibility
• Maintaining control of the company
• Ensuring a balance between risk and return

Theories of Capital Structure

For UGC NET, understanding the following capital structure theories is crucial:

1. Net Income (NI) Approach

• Proposed by David Durand
• Suggests that capital structure influences the value of a firm
• Increase in debt lowers the overall cost of capital and increases firm value

2. Net Operating Income (NOI) Approach

• Also by Durand
• Opposes NI approach
• Asserts that capital structure is irrelevant and does not affect firm value

3. Traditional Approach

• A compromise between NI and NOI
• Suggests there is an optimal capital structure where the cost of capital is minimized and firm value is maximized

4. Modigliani and Miller (MM) Approach

• Proposed by Franco Modigliani and Merton Miller
• Assumes perfect capital markets
• States that in the absence of taxes, capital structure does not impact firm value
• With taxes, debt financing becomes advantageous due to the tax shield

Factors Influencing Capital Structure

UGC NET exams often test conceptual understanding of the determinants of capital structure, such as:

• Nature and Size of Business
• Profitability and Cash Flows
• Cost of Debt and Equity
• Control Considerations
• Market Conditions
• Regulatory Environment

Capital Structure vs Financial Structure

Optimal Capital Structure

The optimal capital structure is the one that:

• Minimizes the Weighted Average Cost of Capital (WACC)
• Maximizes the value of the firm
• Maintains an appropriate balance between debt and equity

Sample UGC NET MCQ on Capital Structure

Q: According to the Modigliani and Miller approach (with no taxes), the value of a firm is:

A) Dependent on capital structure
B) Independent of capital structure
C) Maximized at 100% debt
D) Minimised at 100% equity

Answer: B) Independent of capital structure

Conclusion

Capital structure is not just an academic concept—it plays a strategic role in business decisions. For UGC NET Commerce Paper 2, focus on understanding the definitions, theories, comparisons, and practical implications. Practice MCQs and case-based questions to test your understanding.

Stay consistent in your preparation and remember—conceptual clarity is key to cracking UGC NET.

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