Pdf despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. This is the maximum amount of credit that can be extended by lenders. The capital structure of the firm represents its investment and financing strategy. Irrelevance theorem a benchmark striking result is that under fairly general conditions, the value of the firm defined as the sum of value of debt and. In general, capital structure is the amount of equity and the amount of debt on hand at a given company. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. Structure definition of structure by merriamwebster. For this conference, this definition is too narrow. Capital structure is a part of the financial structure and refers to the proportion of the various longterm sources of financing. A company with a complex capital structure might have a combination of.
It is the permanent financing of a firm represented by longterm debt, preferred stock and net worth. Equity capital is the funds that the firms owners are trusting with the company and the retained earnings that represent profits from previous years, which are not distributed to the shareholders as dividends but are used towards the financing of debt or expansion of business. By examining the role of business risk, financial leveraging, financial distress, and taxes, we can explain some of the variation in debt ratios between industries. The capital structure of a firm is some mix of debt, internally generated equity, and new. The capital structure of a business firm is essentially the right side of its balance sheet. The term capital structure refers to the relationship between the various longterm forms of financing such as debenture, preference share capital and equity share capital. Capital structure in financial term means the way a firm finances their assets through the combination of equity, debt, or hybrid securities saad, 2010. Capital structure how investment asset ownership is financed. Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity financing to use for operations and expansions. Capital structure is the mix of ownersupplied capital equity, reserves, surplus and borrowed capital bonds, loans that a firm uses to finance business. Structural capital is owned by an organization and remains with an organization even when people leave. Capital structure definition is the makeup of the capitalization of a business in terms of the amounts and kinds of equity and debt securities. Debt comes in the form of bond issues or longterm notes. Traditionally this question has focused on publiclytraded corporations, but much real estate investment is made more directly, not.
A firms capital structure is the composition or structure of its liabilities. In other words, it includes all longterm funds invested in the business in the form of longterm loans, preference shares and debentures, including equity. Nov 12, 2018 capital structure is the composition of longterm liabilities, specific shortterm liabilities, like bank notes, common equity, and preferred equity, which make up the funds a business firm uses for its operations and growth. Modigliani and miller 1958 were the first ones to landmark the topic of capital structure and they argued that capital structure was. May 29, 2019 since capital structure is the amount of debt or equity or both employed by a firm to fund its operations and finance its assets, capital structure is typically expressed as a debttoequity ratio. Capital structure describes the amount of debt a company uses as opposed to equity, and it is often measured with the ratio of debt to equity. Capital structure of a firm is a reflection of the overall investment and financing strategy of the firm. Organizational capital are elements of organizational culture that are independent of employees. A firms capital structure may contain many components, including the following. A21 that it is important to maintain optimum levels of debt and equity in that capital structure, decision makers must constantly be in control of capital structure determinants. A definition of organizational capital with examples. The more debt a company has, the more it has to pay creditors for the use of those funds.
The cost depends on the health of the companys balance sheeta triple aaa rated firm can borrow at extremely low rates vs. Capital structure is defined as the mix of debt and equity securities used to finance real investment. Capital structure ratios fundamentals of accounting. This is a type of intellectual capital that includes any structures that help employees to be more productive and creative. As a rule of thumb, the higher the proportion of debt financing a company has, the higher its exposure to risk will be. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to finance its core operations through equity. Jun 25, 2019 the debt capital in a companys capital structure refers to borrowed money that is at work in the business. The theory of capital structure wiley online library. These ratios indicate the mix of funds provided by the owners and lenders and assure the lenders of the long term fund with respect to.
When a business wants to grow it will need capital to drive its expansion. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known empirical evidence. Common stock multiple classes of preferred stock bonds debt having different terms and maturity dates retai. Capital structure definition of capital structure by. This means that managers will use the excess free cash flow available to fulfil his personal interests instead of increasing returns to the shareholders. Capital structure is the particular combination of debt and equity used by a company to funds its ongoing operations and continue to grow. The capital structure of a company is made up of debt and equity securities that comprise a firms financing of its assets. Use of debt vs equity how much of each as sources of financial capital. Capital structure financial definition of capital structure. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. A read is counted each time someone views a publication summary such as the title, abstract, and list of authors, clicks on a figure, or views or downloads the fulltext. So it relates to the arrangement of capital and excludes shortterm borrowings. The theory of capital structure milton harris and artur raviv abstract this paper surveys capital structure theories based on agency costs, asymmetric information, productinput market interactions, and corporate control considera tions but excluding taxbased theories.
Capital structure theory financial definition of capital. Apr 12, 2019 capital structure is an integral underlying model for capital creation. Financing the firms assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing. The mix of debt and equity used to finance the companys future profitable investment opportunities is referred to as capital structure. Chapter iii concepts and theories of capital structure and profitability. The three most basic ways to finance are through debt, equity or the issue of stock, and, for a small business. The capital employed consists of both the owners capital and the debt capital provided by the lenders. Apr 24, 2020 capital structure definition is the makeup of the capitalization of a business in terms of the amounts and kinds of equity and debt securities. Capital structure is the mix of debt and equity that a business uses to fund its operations.
Capital structure is the allocation of debt and equity that a firm uses to fund its operations and expansions. It is concerned with making the array of the sources of the funds in a proper manner, which is in relative magnitude and proportion. Capital structure ratios are also known as leverage ratios. It is the employment of an asset source of finance for which. Unfortunately, there has been little consensus among researchers on what the optimal capital structure is. The paper explores a vast body of literature in articulating critical issues in capital structure decision. Capital structure is also referred as financial structure of a firm.
Capital structure is the composition of longterm liabilities, specific shortterm liabilities, like bank notes, common equity, and preferred equity, which make up the funds a business firm uses for its operations and growth. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital wacc wacc wacc is a firms weighted average cost of capital and represents its blended cost of capital including equity and debt. Capital structure is commonly known as the debttoequity ratio. Capital structure reflects the firms financing strategy, for. Capital structure reflects the firms financing strategy, for example, its overall target debtequity ratio, and also financing tactics, for example, the design and timing of a particular debt issue. Capital structure theory asks what is the optimal composition between debt and equity. The survey would then proceed to document the answers available in the litera ture. The study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance.
Structural capital is one of the three primary components of intellectual capital, and consists of the supportive infrastructure, processes, and databases of the organisation that enable human capital to function. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital wacc wacc. Structural capital is the supportive nonphysical infrastructure that enables human capital to function. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. The capital structure of a firm is very important since it related to the ability of the firm to meet the needs of its stakeholders. Capital structure usually refers to how much of each type of financing a company holds as a percentage of all its financing. Capital structure is still a puzzle among finance scholars. Since capital structure is the amount of debt or equity or both employed by a firm to fund its operations and finance its assets, capital structure is typically expressed as a. Capital structure ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. Capital market conditionin the lifetime of the company, the market price of the shares has got an important influence. Capital structure policy involves a tradeoff between risk and return 1 using more debt raises the riskiness of the firms earnings stream.
Capital structure how a company finances its operations. Introduction capital structure refers to the different options used by a firm in financing its assets bhaduri, 2002. The use of different forms of securities rather than relying solely on one class of common stock. There are three subcomponents that comprise structural capital. Capital structure refers to an arrangement of the different components of business funds, i. Capital structure definition and meaning collins english. Exhibit 1 flow of funds between the suppliers of capital and the company the combination of debt and equity used to finance a companys projects is referred to as capital structure. Capital structure refers to the different options used by a firm in financing its assets bhaduri, 2002. A business organization utilizes the funds for meeting the everyday expenses and also for budgeting highend future projects. Capital structure is an integral underlying model for capital creation. During the depression period, the companys capital structure generally consists of debentures and loans. Capital structure means the structure or constitution or breakup of the capital employed by a firm. Although the focus of this paper is on the role of taxes in capital structure, the framework used here is not limited to that question. Capital structure refers to the permanent financing of the company, represented by owned capital and loandebt capital i.
Generally, a firm can go for different levelsmixes of debts, equity, or other financial arrangements. Capital structure a reading prepared by pamela peterson drake outline 1. Generally speaking, a company with a high level of debt compared to equity is thought to carry higher risk, though some analysts do not believe that capital structure matters to risk or profitability. The literature, building on mertons insights, has attempted to tackle these. Capital structure wharton finance university of pennsylvania. Equity capital is the funds that the firms owners are trusting with the company and the retained earnings that represent profits from previous years, which are not distributed. Capital structure the makeup of the liabilities and stockholders equity side of the balance sheet, especially the ratio of debt to equity and the mixture of short and long maturities. But neither of these two theories provide a complete description why some firms prefer debt and others prefer equity finance under different. Capital structure is the mix of ownersupplied capital equity, reserves, surplus and borrowed capital bonds, loans that a firm uses to finance business operations.
The debt capital in a companys capital structure refers to borrowed money that is at work in the business. The purpose of capital structure is to provide an overview of the level of the companys risk. A firm can raise new capital either by borrowing i. A business organization utilizes the funds for meeting the everyday expenses. Capital structure, as its name itself signifies, is the composition of the capital employed by the firm from various sources of finance.450 908 116 162 55 130 1292 918 1490 532 939 510 145 995 693 1179 988 521 1363 904 951 290 231 129 1331 940 123 1317 320 358 266 1461 1197