Capital structure

Capital structure

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In finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, capital structure refers to the way a corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

 finances its assets through some combination of equity
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

, debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

, or hybrid securities
Hybrid security
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.Hybrid securities pay a predictable rate of return or dividend until a certain date, at which point the holder has a number of options including converting the...

. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $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 (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...

. In reality, capital structure may be highly complex and include dozens of sources.
Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem
Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...

, proposed by Franco Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...

 and Merton Miller
Merton Miller
Merton Howard Miller was the co-author of the Modigliani-Miller theorem which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William Sharpe...

, 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 decision. 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, and information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

. 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.

Capital structure in a perfect market

Consider a perfect capital market (no transaction or bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....

 costs; perfect information
Perfect information
In game theory, perfect information describes the situation when a player has available the same information to determine all of the possible games as would be available at the end of the game....

); firms and individuals can borrow at the same interest rate; no tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

es; and investment decisions aren't affected by financing decisions. 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, while the burden of individual risks is shifted between different investor classes, total risk is conserved 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 decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.

Capital structure 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 M&M model.

Trade-off theory

Trade-off theory allows the bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....

 cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt
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 around the world, and until recently under the U.S...

) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is 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 D/E ratios between industries, but it doesn't explain differences within the same industry.

Pecking order theory

Pecking Order theory 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, then 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 is popularized by Myers (1984) when he argues 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 that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.

Agency Costs

There are three types of agency costs
Agency cost
An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...

 which can help explain the relevance of capital structure.
  • Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV
    NPV can refer to:* Net present value, an economic standard method for evaluating competing long-term projects in capital budgeting* Negative predictive value, in biostatistics, the proportion of patients with negative test results who are correctly diagnosed...

    ) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders.
  • Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders 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
    Free cash flow
    In corporate finance, free cash flow is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on....

     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.


  • The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value.
  • Market timing
    Market timing
    Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...

     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 use to invest faster because of the existence of default risk.

Capital gearing ratio

Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk)
  • Capital bearing ratio includes debentures(risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).
  • Capital not bearing risk includes equity share capital.

Therefore we can also say,

Capital gearing ratio= (Debentures+Preference share capital) : (Equity shareholders' funds)


Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...


A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bond
Convertible bond
In finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...

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

  • Capital structure substitution theory
    Capital structure substitution theory
    In finance, the capital structure substitution theory describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share are maximized...

  • Cost of capital
    Cost of capital
    The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...

  • Corporate finance
    Corporate finance
    Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...

  • Debt overhang
    Debt overhang
    Debt overhang is when an organization 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 than pay for itself....

  • Discounted cash flow
    Discounted cash flow
    In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...

  • Enterprise value
    Enterprise value
    Enterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...

  • Financial modeling
    Financial modeling
    Financial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other investment...

  • Financial economics
    Financial economics
    Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....

  • Pecking Order Theory
    Pecking Order Theory
    In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984...

  • Triple Accounting
  • Weighted average cost of capital
    Weighted average cost of capital
    The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....

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