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How a company finances its operations. The three most basic ways to finance are through debt,
equity (or the issue of stock), and, for a small business, personal savings. Capital structure
usually refers to how much of each type of financing a company holds as a percentage of all its
financing. Generally speaking, a company with a high level of debt compared to equity is
thought to carry higher risk, though some analysts do not believe that capital structure matters to
risk or profitability.
Capital Structure

In finance,
   

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 assumes away 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 Ê
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.

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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. 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.




  

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The combination of a company's long-term debt, specific short-term debt, common equity, and
preferred equity; the capital structure is the firm's various sources of funds used to finance its
overall operations and growth. Debt comes in the form of bond issues or long-term notes
payable, whereas equity is classified as common stock, preferred stock, or retained earnings.
Short-term debt such as working capital requirements also is considered part of the capital
structure.

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÷Y In practice, it¶s fair to say that none of the assumptions are met in the real world, but what
the theorem teaches is that capital structure is important because one or more of the
assumptions will be violated. By applying the theorem¶s equations, economists can find
the determinants of optimal capital structure and see how those factors might affect
optimal capital structure.

   


÷Y Modigliani and Miller¶s theorem, which justifies almost unlimited financial leverage, has
been used to boost economic and financial activities. However, its use also resulted in
increased complexity, lack of transparency, and higher risk and uncertainty in those
activities. The global financial crisis of 2008, which saw a number of highly leveraged
investment banks fail, has been in part attributed to excessive leverage ratios.

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The proportion of short-term and long-term debt is considered in analyzing a firm's capital
structure. When people refer to capital structure, they most likely are talking about a firm's
debt/equity ratio, which provides insight into how risky a company is. Usually a company
financed heavily by debt poses greater risks because it is highly leveraged.

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The effective rate that a company pays on its current debt; it can be measured as either before-tax
or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen




  

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most often. This is one part of the company's capital structure, which also includes the cost of
equity.

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Companies use bonds, loans, and other forms of debt for capital; this measure is useful because it
indicates the overall rate being
used for debt financing. It also gives investors an idea of how risky a company can be; riskier
companies generally have a higher cost of debt. To get the after-tax rate, multiply the before-tax
rate by 1 minus the marginal tax rate (before-tax rate × (1 - marginal tax)). For example, if a
company's only debt was a single bond in which it paid 5%, the before-tax cost of debt would be
5%. If, however, the company's marginal tax rate was 40%, the company's after-tax cost of debt
would be only 3% (5% × (1 -40%)).


   

The acquisition of funds by borrowing. For example, a business may use debt financing to raise
funds for constructing a new factory. Corporations find debt financing attractive because the
interest paid on borrowed funds is a tax-deductible expense. Compare equity financing.
Debt Financing
The act of a business raising operating capital or other capital by borrowing. Most often, this
refers to the issuance of a bond, debenture, or other debt security. In exchange for lending the
money, bond holders and others become creditors of the business and are entitled to the payment
of interest and to have their loan redeemed at the end of a given period. Debt financing can be
long-term or short-term. Long-term debt financing usually involves a business' need to buy the
basic necessities for its business, such as facilities and major assets, while short-term debt
financing includes debt securities with shorter redemption periods and is used to provide day-to-
day necessities such as inventory and/or payroll. See also: Equity financing.


  

 

  


When a firm raises money for working capital or capital expenditures by selling bonds, bills, or
notes to individual and/or institutional investors. As a result of lending the money, the
individuals or institutions become creditors and fully expect to be repaid on the principal and
interest.


  

Besides debt financing, the other way to raise capital is to issue shares of stock in a public
offering. This is called equity financing.








  
 
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An obligation having a maturity of more than one year from the date it was issued. Also called
funded debt.
Long-Term Debt
Bonds, loans, and any other debt with a maturity of longer than one year. Long-term debt is used
for capital outlays, which usually involves a business' need to buy the basic necessities for its
operations, such as facilities and major assets. It is also called funded debt.

Technically, that portion of any debt that will come due after 1 year from the current date. A
newly made 30-year mortgage would have 1 year of payments posted to shortterm debt on the
accounting books of the borrower, and 29 years posted to long-term debt. In common parlance,
though, it is simply any debt with a maturity greater than 1 year from the time of making.

 
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Loans and financial obligations with maturities lasting over a year; in the United Kingdom, long-
term debts are known as long-term loans.

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As an example, debt obligations such as bonds and notes that have maturities greater than one
year are considered long-term debt. Loans such as T-bills and commercial paper are not
considered longterm debt because their maturities are typically less than one year.

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The accumulated net income that has been retained for reinvestment in the business rather than
being paid out in dividends to stockholders. Net income that is retained in the business can be
used to acquire additional income-earning assets that result in increased income in future years.
Retained earnings is a part of the owners' equity section of a firm's balance sheet. Also called
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retained earnings, statement of retained earnings.

 
 

The amount of a publicly-traded company's post-tax earnings that are not paid in dividends. Most
earnings retained are re-invested into the company's operations. Year-on-year tracking of the
ratio of undistributed profits to dividends is important to fundamental analysis to investigate
whether a company is increasing or decreasing its rate of re-investment. Undistributed profits
form part of a company's equity, and are owned by shareholders. They are also called retained
earnings, accumulated profits, undivided profits, and earned surplus.




  

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Retained earnings, also known as retained surplus, are the portion of a company's profits that it
keeps to reinvest in the business or pay off debt, rather than paying them out as dividends to its
investors.

Retained earnings are one component of the corporation's net worth and increase the supply of
cash that's available for acquisitions, repurchase of outstanding shares, or other expenditures the
board of directors authorizes.

Smaller and faster-growing companies tend to have a high ratio of retained earnings to fuel
research and development plus new product expansion. Mature firms, on the other hand, tend to
pay out a higher percentage of their profits as dividends.

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Also called retention ratio or retained surplus, it is the percentage of net earnings not paid out as
dividends but retained by the company to be reinvested in its core business or to pay debt. It is
recorded under shareholders' equity on the balance sheet. It is calculated by adding net income to
or subtracting any net losses from beginning retained earnings and subtracting any dividends
paid to shareholders, as shown here:

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In most cases, companies retain their earnings to invest them in areas where the company can
create growth opportunities, such as buying new machinery or spending the money on research
and development. If a net loss is greater than beginning retained earnings, retained earnings can
become negative, creating a deficit.




  
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