The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: In this section, we'll consider the importance of capital structure. A company's capitalization not to be confused with market capitalization describes its composition of permanent or long-term capital, which consists of a combination of debt and equity. A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength.
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July Learn how and when to remove this template message 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 systemthe tax-deductibility of interest makes debt financing valuable; that is, the cost of capital Capital structure management as the proportion of debt in the capital structure increases.
The optimal structure would be to have virtually no equity at all, i. In the real world[ edit ] If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance.
Trade-off theory[ edit ] 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.
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".
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.
As a result, investors may place a lower value to the new equity issuance. Capital structure substitution theory[ edit ] 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 SEC rule 10b allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure. First, it has been deducted[ by whom? 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.
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.
Agency costs[ edit ] Three types of agency costs can help explain the relevance of capital structure. 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. If debt is risky e. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.
Increasing leverage imposes financial discipline on management. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications.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. Capital Structure Management A company’s capital structure refers to the combination of its various sources of funding.
Most companies are funded by a mix of debt and equity, including some short-term debt, some long-term debt, a number of shares of common stock, and perhaps shares of .
Capital structure is a part of the financial structure and refers to the proportion of the various long-term sources of financing. It is concerned with making the array of the sources of the funds in a proper manner, which is in relative magnitude and proportion.
The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital.
Clarifying Capital Structure-Related Terminology The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet.
It is the goal of company management to find the optimal mix of debt and equity, also referred to as the optimal capital structure. Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by equity.