Capital structure

In finance, particularly corporate finance capital structure is the way a corporation finances its assets through some combination of , debt, or hybrid securities.

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:

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.

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