Capital Structure – Definition

Cite this article as:"Capital Structure – Definition," in The Business Professor, updated March 8, 2019, last accessed December 4, 2020, https://thebusinessprofessor.com/lesson/capital-structure-definition/.

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Capital Structure Definition

Capital Structure is a company’s or an organization’s financial structure is its way of financing its operational costs or expansion. Most companies will resort to loans or shares. In this case, capital refers to the amount of money available to a company; this includes all monies contributed by owners/shareholders and that obtained from loans.

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:

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

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.

References for Capital Structure

Academic Research on Capital Structure

  • The determinants of capital structure choice, Titman, S., & Wessels, R. (1988). The Journal of finance, 43(1), 1-19. This paper examines the capital structure theories in three different ways. First, it analyzes most of the capital theories empirically for a deeper understanding. Second, it analyzes debts in its different types including short and long term debt. Third, the paper, uses a factor-analytic technique to reduce errors that may be experienced when using proxy variables.
  • What do we know about capital structure? Some evidence from international data, Rajan, R. G., & Zingales, L. (1995). What do we know about capital structure? Some evidence from international data. The journal of Finance, 50(5), 1421-1460. This paper examines the factors that influence the choice of capital structure. It was found that, the factors that influence these decisions are the same across many countries.
  • The theory of capital structure, Harris, M., & Raviv, A. (1991). The theory of capital structure. the Journal of Finance, 46(1), 297-355. This research looks at the theories of capital structure in relation to agency costs, market interactions, asymmetric information, and corporate control considerations. It analyzes different models or capital structure and then compares these models.
  • Optimal capital structure under corporate and personal taxation, DeAngelo, H., & Masulis, R. W. (1980). Optimal capital structure under corporate and personal taxation. Journal of financial economics, 8(1), 3-29.  This paper formulates a model of corporate leverage decisions in which taxes exist and where supply side adjustments by companies determine the equilibrium of debts and equity.
  • Market timing and capital structure, Baker, M., & Wurgler, J. (2002). Market timing and capital structure. The journal of finance, 57(1), 1-32.  This paper observes that entities issue equity only when their market value rises and repurchases equity when their market value goes down. It also observes that the prevailing capital structure of companies is greatly influenced by historical market values. The paper continues to say that, capital structure can be referred to as the cumulative outcome of historical attempts to tame the equity market.
  • Testing the pecking order theory of capital structure, Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of financial economics, 67(2), 217-248.  This paper tests the pecking theory of capital structure. The paper finds that, contrary to this theory, net equity issues are associated with financial deficits more than net debt issues.
  • Corporate debt value, bond covenants, and optimal capital structure, Leland, H. E. (1994). Corporate debt value, bond covenants, and optimal capital structure. The journal of finance, 49(4), 1213-1252.  This paper looks at the relation between capital structure and corporate debt values. It observes that optimal leverage and debt values are related to taxes, firm risks, risk-free interest rates, bankruptcy costs, bond covenants and payout rates. The results of this study explains the behavior of junk bonds compared to investment-grade bonds, asset substitution, debt renegotiation and debt repurchase.
  • The effect of capital structure on a firm’s liquidation decision, Titman, S. (1984). The effect of capital structure on a firm’s liquidation decision. Journal of financial economics, 13(1), 137-151.  This paper observes that the liquidation can impose costs on its workers, customers and suppliers. The firm has a relationship with its working, customers and suppliers. This paper suggests that a good capital structure can solve this problem by acting as a bonding mechanism.
  • Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads, Leland, H. E., & Toft, K. B. (1996). Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads. The Journal of Finance, 51(3), 987-1019.  This article studies optimal capital structure of a company that has the privilege of choosing the amount and the maturity of its debts. The paper notes long term debts, unlike short term debts, exploit tax benefits completely but short term debts provide incentive compatibility between equity and debt holders. It also states that asset substitution costs by agency are reduced by short term debts. From these findings, the paper suggests that tax advantage of debt needs to be balanced against agency costs and bankruptcy when determining optimal capital structure. Further, the article suggests that different term structures of debt are needed for different levels of risk.
  • Managerial entrenchment and capital structure decisions, Berger, P. G., Ofek, E., & Yermack, D. L. (1997). Managerial entrenchment and capital structure decisions. The journal of finance, 52(4), 1411-1438. This article studies the relationship between managerial entrenchment and the capital structure of firms. The study shows that most CEOs in firms that are struggling financially avoid debts. It also observed that in firms where CEOs are not under pressure from owners, leverage levels tend to be lower. After analyzing leverage, the article found that leverage rises after an entrenchment-reducing shock.
  • Dynamic capital structure choice: Theory and tests, Fischer, E. O., Heinkel, R., & Zechner, J. (1989). Dynamic capital structure choice: Theory and tests. The Journal of Finance, 44(1), 19-40. This paper examines recapitalization costs. Findings in this study show that, even small recapitalization costs have an effect on the debt ratio of a firm over time.
  • Capital structure and the informational role of debt, Harris, M., & Raviv, A. (1990). Capital structure and the informational role of debt. The Journal of Finance, 45(2), 321-349. This article views capital structure from the point of how debts affect how investors access information about a firm and how they oversee management. It shows that managers and CEOs are not quick to relinquish control or provide any information that may cause any negative outcome. The paper also suggests that debt can be used as a disciplining device firms are afraid of being forced into liquidation because that might generate information which will be used by investors.
  • Capital structure decisions: which factors are reliably important?, Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: which factors are reliably important?. Financial management, 38(1), 1-37.  The relative importance of the many factors that contribute to capital structure decisions in major firms in the US are examined in this paper. Some of the factors studied that have a positive effect on leverage include median industry leverage, tangibility, log of assets and expected inflation. Factors that have a negative market leverage include market-to-book assets ratio and profits.

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