Capital Structure – Definition

Cite this article as:"Capital Structure – Definition," in The Business Professor, updated March 8, 2019, last accessed July 6, 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

Businesses have the privilege of deciding their financial structure which in most cases involves combining debts and hybrids. For instance, if a company is financed with 40 million shares and 60 million bonds and loans, it is said to be financed 40 percent with shares and 60 percent with debt.

Capital structure can be complex in instances where there are dozens of financiers. Generally, the decisions on capital structure are influenced by:

  •         The financial risk of the company’s capital. For instance, a company that finances its assets through loans has to increase its yield as financing through debt increases the risk that shareholders run.
  •         A company’s fiscal position. For a financially healthy company, debt is more beneficial than equity but a financially struggling company, debt is burdensome.
  •         Financial flexibility or a company’s ability to obtain capital at the best terms.
  •         Aggressive funding attitude of the management of a company.

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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