Capital Structure Definition, Formula and Theory

The net operating income approach is the opposite of the net income approach. It proposes that there is no relationship between your capital structure and the value of the firm. In effect, the increased shareholders’ risk raises the cost of equity. As such, the higher cost of equity nullifies the advantages you have gained from using the cheaper cost of debt.

capital structure definition

Huge payment for the acquisition of fictitious assets like high payment is made to purchase goodwill etc. Join one of our email newsletters and get the latest insights about selling your business in your inbox every week. It has no interest payments as well as no mandatory fixed payments and no maturity dates .

If we raise additional funds through issue of equity shares then control over company of existing shareholders will be diluted. Existing management control and ownership remains undisturbed with debt finance. Capital structure describes a firm’s finances in terms of the balance between its debt and equity. A business’s management team and other stakeholders will consider the proper mix of debt and equity for their ideal capital structure. The ideal capital structure of a firm is frequently defined as the proportion of debt and equity that outcomes in the least weighted average cost of capital for the firm.

Definition of capital structure

The related increase in earnings per share is called financial leverage or gearing in the United Kingdom and Australia. Financial leverage can be beneficial when the business is expanding and profitable, but it is detrimental when the business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company’s operating income, or bankruptcy may be the result. If the firm does not prosper and profits do not meet management’s expectations, too much debt (i.e., too much leverage) increases the risk that the firm may not be able to pay its creditors. At some point this makes investors apprehensive and increases the firm’s cost of borrowing or issuing new equity. It is important that a company’s management recognizes the risk inherent in taking on debt, and maintains an optimal capital structure with an appropriate balance between debt and equity.

Please help improve this section by adding citations to reliable sources. Please help improve this article by adding citations to reliable sources. I am a mother of a lovely kid, and an avid fan technology, computing and management related topics. After completing my post graduation I thought to start a website where I can share management related concepts with rest of the people.

In order to explain the theories of capital structure we are to use the following systems in addition to the above assumptions. For calculating WACC, managers need to multiply the cost or expense of every capital component by its corresponding weight. Other industries, like banking and insurance, use huge amounts of leverage and their business models require large amounts of debt. Capital structuring is an essential function of the management to maintain a sound financial position of the business and fulfil the financial requirements. Full BioPete Rathburn is a freelance writer, copy editor, and fact-checker with expertise in economics and personal finance.

capital structure definition

This contradicts Hamada who used the work of Modigliani and Miller to derive a positive relationship between these two variables. 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 the total firm risk is constant, and hence no extra value created.

Why Do Different Companies Have Different Capital Structure?

Different types of sources of funds will have different types of costs. Careful decisions have to be made in selecting the size of debt as it increases the risk of the firm. Optimal capital structure is considered to be a perfect mix of debt and equity financing that helps in maximizing the value of a company in the market while it minimizes the cost of the capital at the same time.

One more element of capital structure is working capital which is the cash a company has available. Interest on debt is used to reduce the amount of tax going to the government. Interest on debt is a fixed financial obligation; therefore whatever is saved due to the use of debt in the capital structure is earned by the equity shareholders. Debt capital is used to enhance the earnings for the shareholders by reducing the firm’s overall cost of capital. Capital structure planning focuses on the primary objective of profit maximisation with lowest cost of capital and maximum return to equity shareholders. Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance.

capital structure definition

In planning your firm’s capital structure – that is, deciding whether to use equity or debt or a combination of both – you will be presented with a highly technical and complex process. Factors include business risks, management style, control, exposure to taxes, financial flexibility, and market conditions. During the deflation period a company should adopt the policy of low gearing and should issue variable cost bearing capital i.e., equity share capital more and more.

Thus, the form of debt a firm chooses can act as a signal of its need for external finance. 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. Empirically, this theory may explain differences in debt-to-equity ratios between industries, but it doesn’t explain differences within the same industry.

Capital Structure Definition

It is the goal of company management to find the ideal mix of debt and equity, also referred to as the optimal capital structure, to finance operations. Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity.

These include business risks, management style, control, exposure to taxes, financial flexibility, and market conditions. The term ‘capital structure’ differs from the term ‘financial structure’. Financial structure refers to the way the assets of the firm are financed, In other words, it includes both long-term and short-term capital structure definition sources of funds. Basically, it is determined by the mixture of long-term debt and equity used by the firm to finance its operations. The terms ‘capital structure’ and ‘financial structure’ are often used interchangeably. Capital gearing determines the ratio between different types of securities and total capitalisation.

  • Leverage ratios are one group of metrics that are used, such as the debt-to-equity (D/E) ratio or debt ratio.
  • A company’s capital structure is a function of the nature of its business and how risky the particular business is and therefore, a matter of business judgment.
  • According to Gertenberg, capital structure refers to the makeup of a firm’s capitalization.
  • That is why significant variations among industries and among different individual companies within an industry regarding capital structure are noted.

DividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. Have the right over the business’s retained earnings after paid preference shareholders. ShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company.

Capital Structure – Meaning and Factors Determining Capital Structure

In the second approach, the firm will borrow money (i.e., issue debt) and use that money to pay a one-time special dividend, which has the effect of reducing the value of equity by the value of the divided. The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity. Assuming that a company has access to capital (e.g. investors and lenders), they will want to minimize their cost of capital.

An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains. Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders. For example, if Elephant Inc. decides to acquire Squirrel Co. using its own shares as the form of consideration, it will increase the value of equity capital on its balance sheet. If, however, Elephant Inc. uses cash to acquire Squirrel Co., it will have increased the amount of debt on its balance sheet. In the third approach, the firm moves in the opposite direction and issues equity by selling new shares, then takes the money and uses it to repay debt.

Leverage or capital gearing ratios

Cyclical industries like mining are often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay the debt. Both small businesses and Fortune 500 companies are trying to determine how much of their start-up fund should be sourced from a bank loan without endangering their business. The neutral mutation hypothesis — firms fall into various financing habits that do not impact value. So, caution should be taken not to give too much away that owners lose their controlling stake.

Since WACC is the required return on investors’ money, it’s often used by management in making long-term decisions, such as mergers and company expansion. This capital comes in many forms – long and short-term debts, secured and unsecured debts, preference shares, equity shares, retained earnings and other things. To decide upon the ratio of these securities in the total capitalization is termed as capital structure. Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure.

To put it all together, capital structure alludes to the percentage of capital at work in a business by type. Overall, the capital structure comes in two forms- equity capital and debt capital. The subsequent prediction has been that firms with a high valuation ratio or low earnings yield will have next to zero debt though firms with low valuation ratios will be more leveraged.

The proportion of short-term debt versus long-term debt is viewed while investigating the capital structure of a firm. Capital structure refers to the composition or make up of the long-term sources of funds in the total capital of a company. Our main concern is to find the effect on the total value of the firm and the overall cost of capital when the ratio of debt to equity or the relative amount of financial leverage is varied. Again they may get a dividend lower than that on the preference shares when the company makes some profits. Hence the equity shares are also called ‘variable yield-bearing securities’ or ‘risk-bearing securities’. Thus, capitalisation represents total amount of long-term capital while capital structure represents the form and structure of long-term capital.

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