In finance, particularly corporate finance capital structure is the way a corporation

finances its assets through some combination of equity, debt, or hybrid securities.

Contents [hide]
1

Overview

Capital Structure Theory

2.1

ModiglianiMiller theorem

In the real world

3.1

Trade-off theory

3.2

Pecking order theory

3.3

Capital Structure Substitution Theory

3.4

Agency Costs

3.5

Structural Corporate Finance

3.6

Other

Capital gearing ratio

Arbitrage

See also

References

Further reading

External links

Overview[edit]

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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.[1] 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 of the capital structure comes into play. A
typical company has the following seniority structure listed from most senior to
least:

Senior debt
Subordinated (or junior) debt
Preferred stock
Common stock
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller 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 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 Theory[edit]

ModiglianiMiller theorem[edit]

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Consider 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 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, risk is shifted between different investor classes, while 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, 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 would be to have virtually no equity at
all, i.e. a capital structure consisting of 99.99% debt.

In the real world[edit]

If capital structure is irrelevant in a perfect market, then imperfections which exist
in the real world must be the cause of its relevance.[citation needed] The theories
below try to address some of these imperfections, by relaxing assumptions made in
the M&M[clarification needed] model.

Trade-off theory[edit]
Trade-off theory of capital structure allows 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 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 of further increases in debt declines as debt increases, while the
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.[citation needed]

Pecking order theory[edit]

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.[citation needed] 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.[citation needed]

The pecking order theory has been popularized by Myers (1984)[2] 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[edit]

The capital structure substitution theory is based on the hypothesis that company
management may manipulate capital structure such that earnings per share (EPS)
are maximized.[3] The model is not normative 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.[citation needed]
This hypothesis leads to a larger number of testable predictions. First, it has been
deducted[by whom?] 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 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.[citation needed] 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[who?] who used the work of Modigliani
and Miller to derive a positive relationship between these two variables.[citation
needed]

Agency Costs[edit]