Capital Structure

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Definition: Capital Structure


Capital Structure


What is the dictionary definition of Capital Structure?

Dictionary Definition


Capital structure is the company’s mix of equity and debt it uses to finance itself.


Full Definition of Capital Structure


Capital structure, capitalization, invested capital. They all mean pretty much the same thing — how much money and from what sources the company has used to build itself up and purchase its assets.

It is the total amount of debt and equity, which can be further broken down into retained earnings, additional paid-in capital, common stock, and preferred stock the company is carrying on its balance sheet. Each of these items is a source of capital for the company.

  • Debt: Borrowings from a bank or from investors in the form of bonds.
  • Equity: Consisting of:
    • Retained earnings: The amount of net income the company has kept and not paid out as dividends to shareholders. It reinvests in itself.
    • Additional paid-in capital: The amount above and beyond the par value of stock the company has received from selling or issuing shares of itself.
    • Common stock: Ownership shares of itself.
    • Preferred stock: Special shares, usually without voting rights and with special dividends.

The company uses these sources of capital to purchase assets to generate revenue and net income. Ideally, it would earn a return on this invested capital that is higher than its cost. If it doesn’t, then the company is destroying capital and will require either future infusions of more capital or go out of business (eventually). Because the cost of the different components of the invested capital varies (primarily debt and equity, with debt being less expensive), the company’s cost of capital is a weighted average cost of capital or WACC.

Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is then the composition or ‘structure’ of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn 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.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, the value of a firm is unaffected by how that firm is financed. 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. These other reasons include bankruptcy costs, agency costs and asymmetric information. 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

Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; 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. That is, you cannot change the size of a cake by cutting it into different-sized pieces. 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 is 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 that 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 bankruptcy costs to exist. It states that there is an advantage to financing with debt, the tax benefit of debt and there is a cost of financing with debt, the bankruptcy 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, however, 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 debt is used first, and when that is depleted debt is issued, and when it is not 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. 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 the 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 on the new equity issuance.

Agency Costs

There are three types of agency costs that 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) projects. This is because if the project is successful, shareholders 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 shareholders.
  • Underinvestment problem: If debt is risky (eg in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value.
  • Free cash flow: unless free cash flow 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.

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 (Baker and Wurgler, 2002).

Arbitrage

Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage.

A capital-structure arbitrageur seeks opportunities created by 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.


Synonyms For Capital Structure


Debt-to-Equity Ratio


Related Phrases


Earnings Before Interest Taxes Depreciation and Amortization
Equity Value
Subordinated Debt
Valuation


Capital Structure FAQ's


What Is Capital Structure?

The capital structure of a company refers to its total outstanding debt and equity. It enables a company to understand what type of funding it is using to fund its overall activities and growth. In other words, it displays the percentages of senior debt, subordinated debt, and equity (common or preferred) in the funding. When calculating capital structure, retained earnings are also listed on the equity side of the balance sheet, while short-term debt is added to the company’s other debts. The goal of capital structure is to provide an overview of the company’s risk level. As a general rule, the greater a company’s proportion of debt financing, the greater its risk exposure. A company that is primarily financed by debt will typically have a more aggressive capital structure, which means that investors who invest in the company are taking a greater risk. However, it should be noted that this risk may well be the primary source of growth for the company.

Debt is defined as any money borrowed from a third party that must be repaid. Equity is a type of ownership stake in a company that does not have to be repaid in any way. Both types of financing are used to acquire assets for the business. Debt may be more appealing because it allows the company’s founder(s) to retain a stake in the company.

There may also be tax advantages, as interest paid on a company’s debts is usually tax-deductible as a legitimate business expense. And when interest rates are low and credit is plentiful, it is simple to obtain debt financing.

Equity is more expensive and also dilutes the company’s ownership, but it is also free. This can be advantageous if earnings begin to fall.

The debt-to-equity ratio is a common term for capital structure.

The capital structure of a company explains how its assets are financed. When a company finances its operations by opening up or increasing capital to an investor (preferred shares, common shares, or retained earnings), it avoids debt risk, lowering the likelihood of bankruptcy. However, all company owners will have a proportional share of the company’s earnings from that point forward. Furthermore, the owner may choose debt funding while maintaining control of the company, increasing operational returns.

Companies that use debt as their primary source of financing, as previously stated, are said to be highly leveraged and will have a more aggressive capital structure. Companies whose primary source of funding is the distribution of equity have more conservative capital structures. High-leveraged companies, on the other hand, have the potential for higher returns, whereas low-leveraged companies will generally grow at a slower rate over time.

A corporate bond issue, a long-term loan, or short-term debt are all examples of debt. The latter has a direct impact on working capital. In contrast, a company that is 70% debt-financed and 30% equity-financed has a debt-to-equity ratio of 70%; this is the leverage. It is critical for a company to manage its debt and equity financing because a favourable ratio will be appealing to potential investors. The debt-to-equity ratio is calculated by dividing a company’s total amount of debt by its total amount of equity.

Shrewd businesses will frequently attempt to achieve an optimal capital structure that maximises the company’s market value while minimising the cost of capital. Debt financing is typically less expensive than equity financing due to the tax benefits it provides. However, companies that become overly leveraged may lose their appeal to all but the most aggressive investors.


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Definition Sources


Definitions for Capital Structure are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 26th January, 2022 | 0 Views.