In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage (or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.[1][2]
Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes.[3]
Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company's capital structure.[4]
Basic concepts
Leverage
Up to a certain point, the use of debt (such as bonds or bank loans) in a company's capital structure is beneficial. When debt is a portion of a firm's capital structure, it permits the company to achieve greater earnings per share than would be possible by issuing equity. This is because the interest paid by the firm on the debt is tax-deductible. The reduction in taxes permits a greater portion of the company’s operating income to be available to investors. 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, which may ultimately lead to bankruptcy. 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.[7][8]
Optimal capital structure
Leverage or capital gearing ratios
Financial analysts use some form of leverage ratio to quantify the proportion of debt and equity in a company's capital structure, and to make comparisons between companies. Using figures from the balance sheet, the debt-to-capital ratio can be calculated as shown below.[17]
The debt-to-equity ratio and capital gearing ratio are widely used for the same purpose.
Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).[18] Capital not bearing risk includes equity.[19]
Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds)[20]
In public utility regulation
Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. Ratemaking practice in the U.S. holds that rates paid by a utility's customers should be set at a level which assures that the company can provide reliable service at reasonable cost. The cost of capital is among the costs a utility must be allowed to recover from customers, and depends on the company's capital structure. The utility company may choose whatever capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes.[21]
Modigliani–Miller theorem
The Modigliani–Miller theorem, proposed by Franco Modigliani and Merton Miller in 1958, forms the basis for modern academic thinking on capital structure. It is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process, such as market fluctuations and financial uncertainty, that may arise 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.
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. Assuming perfect capital markets is considered unrealistic and unattainable, as noted by Modigliani and Miller.
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 the total firm risk is constant, and hence no extra value created.
Variations on the Miller-Modigliani theorem
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 Modigliani–Miller theorem.[22]
Trade-off theory
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 to financing with debt, including bankruptcy costs and the financial distress costs of debt.[23] 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.[24] The marginal benefit of further increases in debt declines as debt increases, while the
Arbitrage
A capital structure arbitrageur seeks to profit from 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 (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will converge.
See also
- Discounted cash flow
- Enterprise value
- Financial accounting
- Financial economics
- Hamada's equation
- Outline of corporate finance
- Structured finance
- Weighted average cost of capital
Further reading
External links
- Dinesh Gajurel, "Capital Structure Management in Nepalese Enterprises," 2005.
- Roy L. Simerly and Mingfang Li, "Re-Thinking the Capital Structure Decision: Translating Research into Practical Solutions," n.d.
References
- Groppelli, A.A. and Nikbakht, Ehsan. Finance Barron's Educational Services, Inc., 2000^
- Milton Harris, Artur Raviv. The Theory of Capital Structure The Journal of Finance, 1991^
- Louiselle, Bruce M. and Heilman, Jane E.. The Case for the Use of an Appropriate Capital Structure in Utility Ratemaking: The General Rule Versus Minnesota. William Mitchell Law Review, Mitchell Hamline School of Law, 1982, retrieved 12 May 2021^