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Capital structure in
corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers a ...
is the way a
corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal ...

corporation
finances its
assets In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as ...
through some combination 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 differe ...

equity
,
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
, or hybrid securities. It refers to the make up of a firm's capitalisation. It is the mix of different sources of long term funds such as equity shares, preference shares, long term debt, and retained earnings.


Overview

A firm's capital structure is the composition or 'structure' of its liabilities. For example, a firm that has $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever *Leverage (album), ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using giv ...
.Fernandes, pN.. Finance for Executives: A Practical Guide for Managers. 2014; chapter 5. In reality, capital structure may be highly complex and include dozens of sources of capital. Leverage (or gearing) ratios represent the proportion of a firm's capital that is obtained through debt which may be either bank loans or bonds. 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 Senior (shortened as Sr.) means "the elder" in Latin and is often used as a suffix As, AS, A/S or similar may refer to: Art, entertainment, and media * As (song), "As" (song), a song by Stevie Wonder * , a Spanish sports newspaper * , academic m ...
* Subordinated (or junior) debt *
Preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital __NOTOC__ A corporation's share capital
*
Common stock Common stock is a form of corporate 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 v ...
The
Modigliani–Miller theoremThe 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 costs, ...
, proposed by
Franco Modigliani Franco Modigliani (18 June 1918 – 25 September 2003) was an Italian-American economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theo ...

Franco Modigliani
and
Merton Miller Merton Howard Miller (May 16, 1923 – June 3, 2000) was an American economist, and the co-author of the Modigliani–Miller theoremThe Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theor ...
in 1958, forms the basis for modern thinking on capital structure, though 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 costsAn agency cost is an economic An economy (; ) is an area of the Production (economics), production, Distribution (economics), distribution and trade, as well as Consumption (economics), consumption of Goods (economics), goods and Service (econom ...
,
taxes A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act accord ...

taxes
, and
information asymmetry In contract theory In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency (law), agency and incentiv ...
. 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.


Theory


Modigliani–Miller theorem

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 creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

bankruptcy
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 perfect and instantaneous knowledge of all market price ...
); 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 In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act accord ...
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 Classical may refer to: European antiquity *Classical antiquity Classical antiquity (also the classical era, classical period or classical age) is the period of cultural history between the 8th century BC and the 6th century AD centred on t ...
, the tax-deductibility of interest makes debt financing valuable; that is, the
cost of capital In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant l ...
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.


In the real world

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 structureA trade-off (or tradeoff) is a situational decision that involves diminishing or losing one quality, quantity, or property of a set or design in return for gains in other aspects. In simple terms, a tradeoff is where one thing increases, and another ...
allows
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

bankruptcy
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 A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law, a legal person is any person A person (plural people or persons) is a being that has certain capacities or attr ...
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 Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
of further increases in debt declines as debt increases, while the
marginal cost In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...

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 ratios 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 In contract theory In economics Economics () is a social science Social science is ...
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 Earnings per share (EPS) is the monetary value of earnings Earnings are the net benefits of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a sing ...

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 or desirable or permissible and others as bad or undesirable or impermissible. A Norm (p ...
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 interest rate, nominal yield on long-term government bonds, and that the stock m ...
'. 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 (Arabic Arabic (, ' or , ' or ) is a Semitic language that first emerged in the 1st to 4th centuries CE.Semitic languages: an international handbook / edited by Stefan Weninger; in collaboration with Geoffrey Khan, Michael P. Str ...
who used the work of Modigliani and Miller to derive a positive relationship between these two variables.


Agency costs

Three types of
agency costAn agency cost is an economic An economy (from Greek language, Greek οίκος – "household" and νέμoμαι – "manage") is an area of the Production (economics), production, Distribution (economics), distribution and trade, as well as Co ...
s 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 ra ...
(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 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 Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and ...
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 Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
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

* The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value. * Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers. * Accelerated investment effect—even in absence of agency costs, levered firms invest faster because of the existence of default risk. * In transition economies, there have been evidences reported unveiling significant impact of capital structure on firm performance, especially short-term debt such as the case of Vietnamese emerging market economy.


Capital gearing ratio

Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk) * Capital bearing risk includes
debenture In corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and ...
s (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate). * Capital not bearing risk includes equity shares capital. Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds)


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 bond In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
s. 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 In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available ...
*
Enterprise valueEnterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value Market may refer to: *Market (economics) A market is a composition of system A system is a group of Interaction, intera ...
*
Financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporat ...
*
Financial economics Financial economics is the branch of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among i ...
*
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 In economics Economics ...
*
Hamada's equation In corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and ...


References


Further reading

*


External links

* Dinesh Gajurel, "Capital Structure Management in Nepalese Enterprises," 2005. https://ssrn.com/abstract=778106 * Roy L. Simerly and Mingfang Li, "Re-Thinking the Capital Structure Decision: Translating Research into Practical Solutions," n.d. http://www.westga.edu/~bquest/2002/rethinking.htm {{Authority control Corporate finance