It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the company's balance sheet.
The larger the debt component is in relation to the other sources of capital, the greater financial leverage (or gearing, in the United Kingdom) the firm is said to have.
Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital.
[1][2] Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States.
[3] Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company's capital structure.
This school of thought is generally viewed as a purely theoretical result, since it assumes a perfect market and disregards factors such as fluctuations and uncertain situations that may arise in financing a firm.
In academia, much attention has been given to debating and relaxing the assumptions made by Miller and Modigliani to explain why a firm's capital structure is relevant to its value in the real world.
When debt is a portion of a firm's capital structure, it permits the company to achieve greater earnings per share than would be possible by issuing equity.
The related increase in earnings per share is called financial leverage or gearing in the United Kingdom and Australia.
[9] An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm.
Internal policy decisions with respect to capital structure and debt ratios must be tempered by a recognition of how outsiders view the strength of the firm's financial position.
Increasing the percentage of short-term debt can enhance a firm's financial flexibility, since the borrower's commitment to pay interest is for a shorter period of time.
Ratemaking practice in the U.S. holds that rates paid by a utility's customers should be set at a level which assures that the company can provide reliable service at reasonable cost.
[21] The Modigliani–Miller theorem, proposed by Franco Modigliani and Merton Miller in 1958, forms the basis for modern academic thinking on capital structure.
[23] Trade-off theory of capital structure allows bankruptcy cost to exist as an offset to the benefit of using debt as tax shield.
The 1982 SEC rule 10b-18 allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure.
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.
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.
[39] In addition to firm-specific characteristics, researchers find macroeconomic conditions have a material impact on capital structure choice.
[41] Levy and Hennessy (2007) highlight that trade-offs between agency problems and risk sharing vary over the business cycle and can result in the observed patterns.
Variation in capital structures is primarily determined by factors that remain stable for long periods of time.