Capital Structure – Definition

Cite this article as:"Capital Structure – Definition," in The Business Professor, updated January 17, 2020, last accessed August 9, 2020, https://thebusinessprofessor.com/lesson/capital-structure-definition-2/.

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Capital Structure Definition

Capitalization structure, also known as capital structure, refers to the overall amount of equity and or debt that a firm uses to finance its assets and fund its general operations. Capital structure is expressed as a debt-to-capital ratio or debt-to-equity ratio. The debt is mostly in the form of long-term notes payable or bond issues. On the other hand, equity comes as retained earnings or preferred or common stock. Also, short-term debts are considered to be part of the capital structure. A good example is the working capital requirements.

A Little More on What is Capital Structure

The capital structure represents a mixture of short-term debt, long-term debt, preferred equity, and common equity. The proportion of a long- and short-term debt is put into consideration during the process of capital structure analysis. So, when you hear analysts talking about capital structure, what they are simply referring to is the debt-to-equity ratio that provides insight into the company’s possible risks.

Companies with heavy debt financing imply that their capital structure is aggressive, and its investors are at a greater risk of losing their investment. It may also be a stepping stone to the company’s growth. On the other hand, companies that use equity more than debt to settle payments for their assets have a low leverage ratio and a conservative capital structure.

When firms have to make tradeoffs, they usually decide whether to raise equity or debt. In this case, it is the duty of managers to ensure that they balance the two to get a capital structure that is optimal. Generally, companies use equity and debt to fund different business activities such as:

Debt Capital vs. Equity Capital

When firms have to make tradeoffs, they usually decide whether to raise equity or debt. In this case, it is the duty of managers to ensure that they balance the two to get a capital structure that is optimal. Generally, companies use equity and debt to fund different business activities such as:

  • Business operations
  • Capital expenditures
  • Acquisitions, including other investments

What optimizing basically means is to achieve a debt-to-equity ratio that is in line with the average of the industry. It can also mean achieving a lower debt-to-equity ratio. For a company to be able to calculate its capitalization structure, it needs to know its equity and debt’s market value.

Companies like issuing debt for various reasons:

  • It provides companies with a tax advantage. The payment of the interest is tax-deductible.
  • Unlike equity, debt allows the business or company to retain ownership
  • Also, when companies are experiencing low-interest rates, it is easy for them to access debt.

Equity capital, on the other hand, is more expensive when you compare it to debt capital, especially when a company is experiencing low-interest rates in the market. However, what makes equity capital favorable is that unlike debt capital, companies are not obliged to pay back in case earnings happen to decline.

Reference for “Capital Structure”

https://www.investopedia.com/terms/c/capitalstructure.asp

https://corporatefinanceinstitute.com › Resources › Knowledge › Finance

https://www.thebalance.com › Investing › Investing for Beginners › Economics

https://en.wikipedia.org/wiki/Capital_structure

https://www.divestopedia.com/definition/723/capital-structure

Academic research on “Capital Structure”

Rethinking the Law Firm Organizational Form and Capitalization Structure, Adams, E. S. (2013). Rethinking the Law Firm Organizational Form and Capitalization Structure. Mo. L. Rev.78, 777.

Analysis of foreign investment impact on the dynamics of national capitalization structure: a computational intelligence approach, Plikynas, D., Sakalauskas, L., & Poliakova, A. (2005). Analysis of foreign investment impact on the dynamics of national capitalization structure: a computational intelligence approach. Research in International Business and Finance19(2), 304-332. Central and Eastern Europe countries are in the political and economic transitional process of merging with the European Union. How has foreign investment already transformed these countries’ economic sectors and how will it affect the national economies in terms of capitalization across economic sectors in the near future? Our prime consideration is portfolio investment impact on the dynamics of respective countries’ capitalization structure in terms of sectorial investment distribution. The proposed method rests on the artificial intelligence approach (neural network method), which is targeted to grasp non-linear dynamics of heterogeneous foreign investment impact on national capitalization structure.

Determining an optimum capitalization structure, Abel, J. E. (1984). Determining an optimum capitalization structure. Public Util. Fortn.;(United States)113(11). The author, whose overall concern is capitalization management, focuses upon the specific question: What is the mix of securities issued by an investor-owned utility company that achieves, at the lowest cost to its customers, the twin goals of common equity issuance at book value and maintenance of a desired bond rating. He develops a long-range planning strategy which must be revised, however, as conditions change. 5 references, 4 tables.

Capitalization Structure: The Effects of Leverage on Growth Prospects, Cawley, L., & Janku, R. (2012). Capitalization Structure: The Effects of Leverage on Growth Prospects. In this paper we quantitatively analyzed capital structure to lead to an understanding of the effects of debt within capital structure. Utilizing EBITDA growth as a proxy for the effects of leverage, we quantitatively analyzed the impact of the capitalization decision. Through the use of a model we analyzed 180 companies to come to conclusions about the EBITDA growth rate necessary as determined by leverage.

A comparison of traditional and newly emerging forms of cooperative capitalization, Barton, D. G. (2004). A comparison of traditional and newly emerging forms of cooperative capitalization (No. 1262-2016-101841). This paper compares the traditional forms of capitalization used by American co-ops to newly emerging forms. It is based on an in-depth review of several case co-ops. A broad framework is provided that may be beneficial in more extensive studies of capitalization practices of cooperatives and similar organizations. It is divided into three parts. Part One outlines the alternative capitalization forms being used by cooperatives and their antecedents, where conversions to other structures and forms have occurred. Two basic capitalization forms have been used by cooperatives: traditional (open) and new generation (closed). Cooperatives using both forms have elected to add new capitalization features, such as use of publicly listed stock, or have elected to convert to different forms, such as an LLC or a C corporation. Several perceived advantages have motivated these changes besides the traditional advantages utilized by cooperative corporations, limited liability and single taxation. They include access to capital, liquidity and appreciability of stock. Part Two provides a brief description of the nature and experience of several modern cooperative organizations using the framework presented in Part One. The descriptions are based on in-depth case studies. The case study selections are from a broad cross-section of cooperatives that include the following: (1) Mid-Kansas Cooperative (traditional, centralized, local grain marketing and farm supply using only internally generated equity); (2) Land O’Lakes (traditional, centralized and federated, regional dairy marketing and processing and farm supply using only internally generated equity and registered debt financing); (3) CHS Cooperatives (traditional, primarily federated, regional grain marketing and processing and farm supply, with the recent addition of publicly listed preferred stock); and (4) U.S. Premium Beef (new generation, centralized, regional beef processing using closely held but tradeable common stock and proposal to convert to an LLC with member and non-member tradeable stock). In addition brief mention is made of other cooperatives including (5) Dakota Growers Pasta (new generation, centralized, regional durum wheat processing with recent conversion to C corporation); (6) South Dakota Soybean Processing (new generation, centralized regional soybean processing with conversion to LLC); (7) Pro-Fac and Birds Eye Foods (new generation centralized regional frozen vegetable processing with publicly listed stock and transition of processing entity, Birds Eye, to majority ownership by investor-oriented partner likely to exit through an IPO) and (8) Gold Kist (traditional, centralized regional poultry processing with proposed conversion to publicly traded C corporation). Part Three will briefly outline some of the challenges facing cooperatives in the future with reference to capitalization.

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