CAPITAL STRUCTURE

DEFINITION

Definitions: Capital structure is the mixture of sources of funds a firm uses (debt, preferred stock, common stock). The amount of debt that a firm uses to finance its assets is called leverage. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unleveled
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.

CAPITAL STRUCTURE THEORY

A firm’s capital structure is determined by the proportions of debt and equity
capital used in financing the firm’s assets.
The financial manager should seek that capital structure which maximizes
the value of the firm (the optimal capital structure).
The capital structure decision and the firm’s leverage position are co-determined.

DETERMINANTS OF THE FIRM’S OPTIMAL CAPITAL STRUCTURE

• The Tax Deductibility of Interest the tax deductibility feature of interest expense tends to increase the use of debt in the firm’s capital structure.
• Financial Risk
The increased financial risk that comes with increased use of debt tends to moderate the use of debt in the firm’s capital structure.
Result: The firm’s optimal capital structure should represent a balance between debt and equity. Such cost advantage that comes from using cheaper debt is just matched by the increase in the increase in financial risk that comes with more debt.

DETERMINATION OF CAPITAL STRUCTURE IN THE REAL WOLRLD

• It is difficult (or impossible) for the financial manager to exactly determine the firm’s optimal capital structure.
• The financial manager needs to consider demand sustainability and volatility as well as cost stability when making the debt/equity choice.
• There probably exists a range of acceptable (optimal) debt/asset ratios.