What Are Capital Budgeting and Capital Structure?
Companies that need financing for operations issue more shares of stock to stockholders, apply for bank loans or issue bonds. After a company creates a capital budget for the short or long term, managers choose their financing sources to create a capital structure that doesn't leave the company in debt or tie up existing assets.
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Capital Structure Definition
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A company's capital structure describes the methods the company uses to finance its operations. Companies typically use multiple financing methods to ensure that there's enough capital for operations if one financing method fails. The capital structure is usually comprised of preexisting cash, stockholder's equity and various types of debt. For example, if a company has $1,000,000 in liquid capital, $250,000 may come from cash reserves, $500,000 from stockholders' shares and $250,000 from a short-term loan provided by a bank. This pool of capital resources makes up the capital structure for the company.
Capital Budgeting Definition
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Companies use capital budgeting to allocate resources for short-term and long-term business plans. A capital budget shows the amount of money available for each project or operation, and the time period to which the budget applies. For example, if a company wants to open a new franchise, the capital budget for the fiscal year would allocate enough money to open, market and operate the new franchise. Capital budgets may contain footnotes that describe the capital structure --- where the money comes from --- for the fiscal year.
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Capital Criteria
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The goal of management is to earn as much money for the company and shareholders as possible. Capital must be structured and budgeted so that income is maximized while allowing for growth. For example, if a company makes $1,000,000 in profit for the year but spends $950,000 on projects intended to grow the company, the income statement shows a net profit of $50,000 for the year. To keep investors and shareholders satisfied, managers must balance capital expenditures with the need to increase company equity.
Consequences
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Companies that structure or balance their capital poorly face financial problems from multiple sources. For example, a company that budgets no capital during the fiscal year for growth projects or expansion has a high tax burden at the end of the year. Capital expenditures are expenses that lower the net income, resulting in lower taxes. Additionally, if a company structures its capital entirely around loan debt, it could see a large portion of its income used for interest payments.
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References
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