Capital Structure

The percentage composition of a company's debt and equity structure used to finance the acquisitions of the company's assets. The capital structure of a company comprises debt and equity. This combination is referred to as the debt-to-equity ratio. This ratio is meaningful in determining the riskiness of a company. Creditors can use this ratio in determining whether a loan should be given to the company. All companies need capital to fund their long-term expansion goals and short-term financing needs. The short-term needs may include investment in inventories, payment of taxes and salaries, advertising, and basic operating expenses. The long-term needs may include purchasing capital equipment, buildings, plants, and other assets that can be used to generate revenues. Companies usually have a target debt-to-equity ratio that they will maintain. This target ratio is also referred to as a target capital structure. Companies can issue long-term and short-term bonds and also can raise money in the capital markets or stock market by issuing shares. The mix of debt and equity is carefully analyzed to make sure that companies maximize shareholder value by maintaining the right debt to equity ratio. Generally, the price of debt is cheaper than the price of equity. Shareholders who provide equity financing will always demand a higher return for investing in a company. This return, on average in the past 80 years, was about 12%. On the other hand, bond holders will expect a lower return. When companies need financing, they have the option to go the debt route or the equity route or a combination of both. Taking on additional debt without any new equity issue will increase the debt ratio and increase the riskiness of the firm if this ratio exceeds 50%. This is especially true if a company experiences a drop in sales and it cannot meet its debt obligations. This will put the company at risk of bankruptcy. Companies can reduce the debt ratio by issuing more equity, which will bring down the debt ratio. For more information, see Emery, Finnerty, and Stowe (2004) and Smart, Megginson, and Gitman (2007).