capital structure

Capital structure refers to the way that a company finances its assets through some collection of equity, debt or some other securities. A firms capital structure is then the arrangement or structure of its liabilities. In reality the capital structure may be a highly complex arrangement and consist of many sources. Gearing ratio (or leverage) is that part of the capital employed by a firm which comes from the outside of the business. The Modigliani-Miller theorem forms the basis for modern thinking about capital structure, although it is generally considered to be a purely theoretical system since it disregards many important factors in the capital structure decision making process.

When a company needs to expand or replace some expensive machinery it may not have enough liquid assets and therefore needs to borrow additional finance. Financing a company through borrowing is cheaper than issuing shares. This is because lenders require a lower rate of return than shareholders and the debt can be offset against pre-tax profit thereby reducing the tax bill. The relationship between debt and equity is the gearing ratio, also called leverage.

The two main feature are explained as follows:

The first feature to consider is that, since interest expense is tax deductible, then the more debt used by the firm, the more wealth created via lower tax payments. This is called a tax shield, which has an evident cash value to shareholders, a ready and apparent gain to gearing. As a firm uses more and more debt, the tax shield will become larger and larger, adding value to the firm. the initial value of the firm is the value of the equity, since at zero debt, the firm is financed totally by equity. As debt is added to the capital structure (the debt ratio increases), the value of the firm rises proportionally because of the tax shelter benefit.

The second feature is that risk increases as the firm adds debt to the capital structure. Debt would be very beneficial at low levels, since it is so much cheaper and provides the tax shield. But as large proportions of debt are taken on, the firm begins to be financially distressed by trying to meet interest payment obligations. The more debt the firm adds, the more financially distressed it becomes, less able to service interest expenses for extreme debt levels. Financial distress costs would include higher returns from both creditors and shareholders, as well as costs directly involved with avoiding bankruptcy and costs associated with financial distress and bankruptcy. These costs, at some point, begin to offset the positive effects of the tax shield, and the value of the firm begins to level off, and then to decline.

If the gearing ratio is too high then there is a risk of financial distress so it is better to keep the ratio low. But to obtain the best return it is assumed that there is an optimal level of gearing that could be calculated and maximise shareholder wealth. The problem is what information needs to be used to obtain the this optimum level. Firms would want to use debt, up to the point where the value of the firm is maximized, the optimal capital structure (optimal debt ratio). This is what we would conclude to be a fully rational capital structure decision. Deviations away from this optimal point will result in a sub-optimal capital structure, and the firm would no longer be maximizing shareholder wealth. The idea of maximizing the value of the firm can also be perceived in terms of minimizing the firm's weighted average cost of capital (WACC). As the firm begins to add debt to its capital structure, the WACC falls because the firm is using more of the cheaper form of financing, debt. At some point, however, the WACC will begin to rise as both creditors and shareholders begin requiring ever-increasing returns as risk rises.

Soureces: Arnold, G., Stretcher, R. and Johnson, S. 'Capital Structure: professional management guidance'