In finance, 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
$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. 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, 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 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, and information asymmetry. 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; firms and
individuals can borrow at the same interest rate; no taxes; and investment returns are
not affected by financial uncertainty. 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, i.e. a capital structure consisting of 99.99% debt.
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 cost to exist. It states that there is an advantage
to financing with debt and that there is a cost of financing with 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 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. 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 when he argues that equity is a less preferred
means to raise capital because when managers 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 which
can help explain the relevance of capital structure.
Asset substitution effect: As D/E increases, management has an increased incentive to undertake
risky 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.
Underinvestment problem: If debt is risky, 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 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
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 and Hennessy
and Whited. 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. Capital structure substitution theory—managements
of public companies manipulate capital structure such that earnings per share are maximized.
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 includes debentures(risk
is to pay interest) and preference capital. Capital not bearing risk includes equity share
capital. Therefore we can also say,
Capital gearing ratio= : 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 grows excessively, then the capital-structure arbitrageur will bet that
it will converge. See also
Capital structure substitution theory Cost of capital
Corporate finance Debt overhang
Discounted cash flow Enterprise value
Financial modeling Financial economics
Pecking Order Theory Weighted average cost of capital
Security References
Further reading Poulsen, Annette. "Corporate Financial Structure".
In David R. Henderson. Concise Encyclopedia of Economics. Indianapolis: Library of Economics
and Liberty. ISBN 978-0865976658. OCLC 237794267. Rosenbaum, Joshua; Pearl, Joshua. Investment
Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John
Wiley & Sons. ISBN 0-470-44220-4. External links
http:papers.ssrn.compapers.cfm?abstract_id=778106 http:www.westga.edu2002/rethinking.htm
http:www.listedall.comlabel/capital%20structure