Business, Legal & Accounting Glossary
Capital structure is the company’s mix of equity and debt it uses to finance itself.
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.
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.
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.
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 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 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.
There are three types of agency costs that can help explain the relevance of capital structure.
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.
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This glossary post was last updated: 4th August, 2021 | 4 Views.