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In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of
shareholders' equity In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $2 ...
,
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
(borrowed funds), and
preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...
, and is detailed in the company's
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
. The larger the debt component is in relation to the other sources of capital, the greater financial
leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever * ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using given resources to ...
(or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater
cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible. Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes. Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company's capital structure. The Miller and Modigliani theorem argues that the market value of a firm is unaffected by a change in its capital structure. This school of thought is generally viewed as a purely theoretical result, since it assumes a perfect market and disregards factors such as fluctuations and uncertain situations that may arise in financing a firm. In academia, much attention has been given to debating and relaxing the assumptions made by Miller and Modigliani to explain why a firm's capital structure is relevant to its value in the real world.


Basic concepts


Leverage

Up to a certain point, the use of debt (such as bonds or bank loans) in a company's capital structure is beneficial. When debt is a portion of a firm's capital structure, it permits the company to achieve greater earnings per share than would be possible by issuing equity. This is because the interest paid by the firm on the debt is tax-deductible. The reduction in taxes permits more of the company's operating income to flow through to investors. The related increase in earnings per share is called
financial leverage In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever ...
or gearing in the United Kingdom and Australia. Financial leverage can be beneficial when the business is expanding and profitable, but it is detrimental when the business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company's operating income, or bankruptcy may be the result. If the firm does not prosper and profits do not meet management's expectations, too much debt (i.e., too much leverage) increases the risk that the firm may not be able to pay its creditors. At some point this makes investors apprehensive and increases the firm's cost of borrowing or issuing new equity.Fernandes, pN.. Finance for Executives: A Practical Guide for Managers. 2014; chapter 5.


Optimal capital structure

It is important that a company's management recognizes the risk inherent in taking on debt, and maintains an optimal capital structure with an appropriate balance between debt and equity. An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm. Internal policy decisions with respect to capital structure and debt ratios must be tempered by a recognition of how outsiders view the strength of the firm's financial position. Key considerations include maintaining the firm's
credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. ...
at a level where it can attract new external funds on reasonable terms, and maintaining a stable dividend policy and good earnings record.


Term structure of debt in capital structure

Once management has decided how much debt should be used in the capital structure, decisions must be made as to the appropriate mix of short-term debt and long-term debt. Increasing the percentage of short-term debt can enhance a firm's financial flexibility, since the borrower's commitment to pay interest is for a shorter period of time. But short-term debt also exposes the firm to greater
refinancing risk Refinancing risk, in banking and finance, is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity. Often, the intention ...
. Therefore, as the percentage of short-term debt in a firm's capital structure increases, equity holders will expect greater returns on equity to compensate for the increased risk, according to a 2022 article in ''The Journal of Finance.''


Seniority

In the event of bankruptcy, the
seniority Seniority is the state of being older or placed in a higher position of status relative to another individual, group, or organization. For example, one employee may be senior to another either by role or rank (such as a CEO vice a manager), or by ...
of the capital structure comes into play. A typical company has the following seniority structure listed from most senior to least: *
senior debt In finance, senior debt, frequently issued in the form of senior notes or referred to as senior loans, is debt that takes priority over other unsecured or otherwise more "junior" debt owed by the issuer. Senior debt has greater seniority in the is ...
, including mortgage bonds secured by specifically pledged property, * subordinated (or junior) debt, including debenture bonds which are dependent upon the general credit and financial strength of the company for their security, *
preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...
, whose holders are entitled to have their claims met before those of common stockholders, and *
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
, which includes
common stock Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Comm ...
and
retained earnings The retained earnings (also known as plowback) of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that peri ...
. In practice, the capital structure may be complex and include other sources of capital.


Leverage or capital gearing ratios

Financial analysts use some form of
leverage ratio In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever i ...
to quantify the proportion of debt and equity in a company's capital structure, and to make comparisons between companies. Using figures from the balance sheet, the debt-to-capitalization ratio can be calculated as shown below. :::{, class="wikitable" , - , debt-to-capitalization ratio = dollar amount of debt/ dollar amount of total capitalization The
debt-to-equity ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two ...
and capital gearing ratio are widely used for the same purpose. :::{, class="wikitable" , - , capital gearing ratio = dollar amount of capital bearing risk/ dollar amount of capital not bearing risk Capital bearing risk includes
debenture In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowle ...
s (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate). Capital not bearing risk includes equity. Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds)


In public utility regulation

Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. Ratemaking practice in the U.S. holds that rates paid by a utility's customers should be set at a level which assures that the company can provide reliable service at reasonable cost. The cost of capital is among the costs a utility must be allowed to recover from customers, and depends on the company's capital structure. The utility company may choose whatever capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes.


Modigliani–Miller theorem

The
Modigliani–Miller theorem The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy c ...
, proposed by
Franco Modigliani Franco Modigliani (18 June 1918 – 25 September 2003) was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon Un ...
and Merton Miller in 1958, forms the basis for modern academic thinking on capital structure. It is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like fluctuations and uncertain situations that may occur in the course of financing a firm. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure ''is'' relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs,
taxes A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...
, and
information asymmetry In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which ca ...
. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm. Consider a perfect capital market (no transaction or
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...
costs;
perfect information In economics, perfect information (sometimes referred to as "no hidden information") is a feature of perfect competition. With perfect information in a market, all consumers and producers have complete and instantaneous knowledge of all market pr ...
); firms and individuals can borrow at the same interest rate; no
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
es; and investment returns are not affected by financial uncertainty. Assuming perfections in the capital is a mirage and unattainable as suggested by Modigliani and Miller. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, risk is shifted between different investor classes, while the total firm risk is constant, and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax-deductibility of interest makes debt financing valuable; that is, the
cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
decreases as the proportion of debt in the capital structure increases. The optimal structure would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt.


Variations on the Miller-Modigliani theorem

If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the Modigliani–Miller theorem.


Trade-off theory

Trade-off theory of capital structure The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger ...
allows
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...
cost to exist as an offset to the benefit of using debt as tax shield. It states that there is an advantage to financing with debt, namely, the
tax benefits of debt In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems ...
and that there is a cost of financing with debt the bankruptcy costs and the financial distress costs of debt. This theory also refers to the idea that a company chooses how much equity finance and how much debt finance to use by considering both costs and benefits. The
marginal benefit In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a good or service describes how much pleasure or satisfaction is gained by consumers as a result of the increase or decrease in consump ...
of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in
debt-to-equity ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two ...
s between industries, but it doesn't explain differences within the same industry.


Pecking order theory

Pecking order theory In corporate finance, the pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their ...
tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means "of last resort". Hence, internal financing is used first; when that is depleted, debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory has been popularized by Myers (1984) when he argued that equity is a less preferred means to raise capital, because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think the firm is overvalued, and managers are taking advantage of the assumed over-valuation. As a result, investors may place a lower value to the new equity issuance.


Capital structure substitution theory

The
capital structure substitution theory In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital stru ...
is based on the hypothesis that company management may manipulate capital structure such that earnings per share (EPS) are maximized. The model is not
normative Normative generally means relating to an evaluative standard. Normativity is the phenomenon in human societies of designating some actions or outcomes as good, desirable, or permissible, and others as bad, undesirable, or impermissible. A norm in ...
i.e. and does not state that management should maximize EPS, it simply hypothesizes they do. The 1982 SEC rule 10b-18 allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure. This hypothesis leads to a larger number of testable predictions. First, it has been deducted that market average earnings yield will be in equilibrium with the market average interest rate on corporate bonds after corporate taxes, which is a reformulation of the '
Fed model The "Fed model" or "Fed Stock Valuation Model" (FSVM), is a disputed theory of equity valuation that compares the stock market's forward earnings yield to the nominal yield on long-term government bonds, and that the stock market – as a whole ...
'. The second prediction has been that companies with a high valuation ratio, or low earnings yield, will have little or no debt, whereas companies with low valuation ratios will be more leveraged. When companies have a dynamic debt-equity target, this explains why some companies use dividends and others do not. A fourth prediction has been that there is a negative relationship in the market between companies' relative price volatilities and their leverage. This contradicts
Hamada A hamada ( ar, حمادة, ) is a type of desert landscape consisting of high, largely barren, hard rocky plateaus, where most of the sand has been removed by deflation. The majority of the Sahara is in fact hamada. Other examples are Negev dese ...
who used the work of Modigliani and Miller to derive a positive relationship between these two variables.


Agency costs

Three types of agency costs can help explain the relevance of capital structure. * Asset substitution effect: As debt-to-equity ratio increases, management has an incentive to undertake risky, even negative
net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...
(NPV) projects. This is because if the project is successful, share holders earn the benefit, whereas if it is unsuccessful, debtors experience the downside. * Underinvestment problem or
debt overhang Debt overhang is the condition of an organization (for example, a business, government, or family) that has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more t ...
problem: If debt is risky e.g., in a growth company, the gain from the project will accrue to debt holders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value. * Free cash flow: unless
free cash flow In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (known as capital expenditures). It is that porti ...
is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.


Structural corporate finance

An active area of research in finance is that which tries to translate the models above as well as others into a structured theoretical setup that is time-consistent and that has a dynamic set up similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in a dynamic structure that approximates reality. A similar type of research is performed under the guise of
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004).


Capital structure and macroeconomic conditions

In addition to firm-specific characteristics, researchers find macroeconomic conditions have a material impact on capital structure choice. Korajczyk, Lucas, and McDonald (1990) provide evidence of equity issues cluster following a run-up in the equity market. Korajczyk and Levy (2003) find that target leverage is counter-cyclical for unconstrained firms, but pro-cyclical for firms that are constrained; macroeconomic conditions are significant for issue choice for firms that can time their issue choice to coincide with periods of favorable macroeconomic conditions, while constrained firms cannot. Levy and Hennessy (2007) highlight that trade-offs between agency problems and risk sharing vary over the business cycle and can result in the observed patterns. Others have related these patterns with asset pricing puzzles.


Capital structure persistence

Corporate leverage ratios are initially determined. Low relative to high leverage ratios are largely persistent despite time variation. Variation in capital structures is primarily determined by factors that remain stable for long periods of time. These stable factors are unobservable.


Growth type compatibility

Firms rationally invest and seek financing in a manner compatible with their growth types. As economic and market conditions improve, low growth type firms are keener to issue new debt than equity, whereas high growth type firms are least likely to issue debt and keenest to issue equity. Distinct growth types are persistent. Consistent with a generalized Myers–Majluf framework, growth type compatibility enables distinct growth types and hence specifications of market imperfection or informational environments to persist, generating capital structure persistence.


Other

* Capital
supply Supply may refer to: *The amount of a resource that is available **Supply (economics), the amount of a product which is available to customers **Materiel, the goods and equipment for a military unit to fulfill its mission *Supply, as in confidenc ...
— capital structure also depends on the relative supply of
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
vs.
debt capital Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a company, typically as growth capital, and is normally repaid at some future date. Debt capital differs from equity or share capital because subscribers ...
available to the firm. * The neutral mutation hypothesis — firms fall into various financing habits that do not impact value. *
Market timing hypothesis The market timing hypothesis is a theory of how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. It is one of many such corporate finance theories, and is often contrasted with t ...
—capital structure is the outcome of the cumulative historical timing of the market by managers. * Accelerated investment effect—even in the absence of agency costs, levered firms invest faster because of the existence of default risk. * In transition economies, there has been evidence reported unveiling the significant impact of capital structure on firm performance, especially short-term debt such as the case of Vietnamese emerging market economy.


Arbitrage

A capital structure arbitrageur seeks to profit from differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds, and convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument ''should'' be the value of the traditional bonds ''plus'' the extra value of the option feature. If the spread (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will converge.


See also

* Discounted cash flow *
Enterprise value Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business (i.e. as distinct from market price). It is a sum of claims by all claimants: creditors (secured and unsecured) ...
*
Financial accounting Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, ...
*
Financial economics Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade". William F. Sharpe"Financia ...
*
Weighted average cost of capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by ...
*
Hamada's equation In corporate finance, Hamada’s equation is an equation used as a way to separate the financial risk of a levered firm from its business risk. The equation combines the Modigliani–Miller theorem with the capital asset pricing model. It is used t ...
* Structured finance


References


Further reading

*


External links

* Dinesh Gajurel,
Capital Structure Management in Nepalese Enterprises
" 2005. * Roy L. Simerly and Mingfang Li,

" n.d. {{Authority control Corporate finance Corporate development