A firm's capital structure is the composition or 'structure' of its liabilities. For example, a firm that has $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources of capital.
Leverage (or gearing) ratios represent the proportion of a firm's capital that is obtained through debt which may be either bank loans or bonds.
In the event of bankruptcy, the seniority of the capital structure comes into play. A typical company has the following seniority structure listed from most senior to least:Senior debt
Subordinated (or junior) debt
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller in 1958, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like fluctuations and uncertain situations that may occur 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. 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 total firm risk is constant, and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax-deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt.
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 M&M model.
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 of financing with debt the bankruptcy costs and the financial distress costs of debt. 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. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in debt-to-equity ratios between industries, but it doesn't explain differences within the same industry.
Pecking order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence, internal financing is used first; when that is depleted, debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance.
The pecking order theory has been popularized by Myers (1984) when he argued that equity is a less preferred means to raise capital, because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think the firm is overvalued, and managers are taking advantage of the assumed over-valuation. As a result, investors may place a lower value to the new equity issuance.
The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share (EPS) are maximized. The model is not normative i.e. and does not state that management should maximize EPS, it simply hypothesizes they do.
The 1982 SEC rule 10b-18 allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure. This hypothesis leads to a larger number of testable predictions. First, it has been deducted that market average earnings yield will be in equilibrium with the market average interest rate on corporate bonds after corporate taxes, which is a reformulation of the ‘Fed model’. The second prediction has been that companies with a high valuation ratio, or low earnings yield, will have little or no debt, whereas companies with low valuation ratios will be more leveraged. When companies have a dynamic debt-equity target, this explains why some companies use dividends and others do not. A fourth prediction has been that there is a negative relationship in the market between companies’ relative price volatilities and their leverage. This contradicts Hamada who used the work of Modigliani and Miller to derive a positive relationship between these two variables.
Three types of agency costs can help explain the relevance of capital structure.Asset substitution effect: As debt-to-equity ratio increases, management has an incentive to undertake risky, even negative Net present value (NPV) projects. This is because if the project is successful, share holders earn the benefit, whereas if it is unsuccessful, debtors experience the downside.
Underinvestment problem or debt overhang problem: If debt is risky e.g., in a growth company, the gain from the project will accrue to debt holders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.
Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.
An active area of research in finance is that which tries to translate the models above as well as others into a structured theoretical setup that is time-consistent and that has a dynamic set up similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in a dynamic structure that approximates reality. A similar type of research is performed under the guise of credit risk research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004).The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value.
Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers.
Accelerated investment effect—even in absence of agency costs, levered firms invest faster because of the existence of default risk.
In transition economies, there have been evidences reported unveiling significant impact of capital structure on firm performance, especially short-term debt such as the case of Vietnamese emerging market economy.
Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk)Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).
Capital not bearing risk includes equity shares capital.
Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds)
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.