Question

Capital structure can best be described as:

a) long-term debt, preferred stock, common stock, and retained earnings

b) common stock, retained earnings, current liabilities, and long-term debt

c) everything on the income statement

d) everything on the left-hand side of the balance sheet

Answer 1

The correct answer is  a) long-term debt, preferred stock, common stock, and retained earnings

1. Equity - A firm raises capital through issue of shares. Preferred stock and Common stock are examples of equity. Shares are issued to the public who pay the consideration in the form of cash. This is one of the major source of capital for a firm. In many instances the owners themselves provide the finances from their own to run the firm. Equity capital is generally used for the long term objectives of the firm. However using equity capital results in dilution of ownership.
2. Debt - This capital is generally in the form of long term loans taken from financial institutions or through the issue of debentures. Here the firm has to repay the loans taken and to the debenture holders. Here the cost of capital is Interest. Banks while granting loans and advances charge certain interest on the borrowing which the borrower has to pay along with the principal amount. Most firms would look form debt financing for fulfilling both short term and long term objectives. However default in repayment of loans may also lead to serious financial implications for the firm.
3. Retained Earnings - The reinvestment of retained earnings is one of the source of capital for a firm. When a firm earns profit it may decide that it will not distribute it among the shareholders as dividend but retain it to finance its future projects. Retained earnings are generated by the firm itself and used for its growth in future by investing in the positive npv projects.