DEFINITION OF 'CAPITAL STRUCTURE'

A mix of a company's long-term debt, specific short-term debt, common equity

and preferred equity. The capital structure is how a firm finances its overall
operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity
is classified as common stock, preferred stock or retained earnings. Short-term
debt such as working capital requirements is also considered to be part of the
capital structure.

INVESTOPEDIA EXPLAINS 'CAPITAL STRUCTURE'

A company's proportion of short and long-term debt is considered when
analyzing capital structure. When people refer to capital structure they are most
likely referring to a firm's debt-to-equity ratio, which provides insight into how
risky a company is. Usually a company more heavily financed by debt poses
greater risk, as this firm is relatively highly levered.
http://www.investopedia.com/terms/c/capitalstructure.asp
In finance, capital structure refers to the way a corporation finances its assets through some
combination of equity, debt, or hybrid securities. A firm's capital structure is then 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[1]. In reality, capital structure may be highly
complex and include dozens of sources of capital.
Leverage (or gearing) ratios represent the proportion of the firm's capital that is obtained through
debt (either bank loans or bonds).
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, 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 includebankruptcy 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.

http://en.wikipedia.org/wiki/Capital_structure

You often hear corporate officers, professional investors, and analysts discuss a
company's capital structure. You may not know what a capital structure is or why you
should even concern yourself with it, but the concept is extremely important because it
can influence not only the return a company earns for its shareholders, but whether or
not a firm survives in a recession or depression. Sit back, relax, and prepare to learn
everything you ever wanted to know about your investments and the capital structure of
the companies in your portfolio!

Capital Structure - What It Is and Why It Matters

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. Each has its own benefits and drawbacks and a substantial part
of wise corporate stewardship and management is attempting to find the perfect
capital structure in terms of risk / reward payoff for shareholders. This is true for
Fortune 500 companies and forsmall business owners trying to determine how
much of their startup money should come from a bank loan without endangering
the business.
Let's look at each in detail:

Equity Capital: This refers to money put up and owned by the shareholders
(owners). Typically, equity capital consists of two types: 1.) contributed capital,
which is the money that was originally invested in the business in exchange for
shares of stock or ownership and 2.) retained earnings, which represents
profits from past years that have been kept by the company and used to
strengthen the balance sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company can
utilize because its "cost" is the return the firm must earn to attract investment. A
speculative mining company that is looking for silver in a remote region of Africa may
require a much higher return on equity to get investors to purchase the stock than a
firm such as Procter & Gamble, which sells everything from toothpaste and shampoo
to detergent and beauty products.

Debt Capital: The debt capital in a company's capital structure refers to

borrowed money that is at work in the business. The safest type is generally

considered long-term bonds because the company has years, if not decades,
to come up with the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper utilized by giants
such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour
loans from the capital markets to meet day-to-day working capital requirements such
aspayroll and utility bills. The cost of debt capital in the capital structure depends on
the health of the company's balance sheet - a triple AAA rated firm is going to be able
to borrow at extremely low rates versus a speculative company with tons of debt,
which may have to pay 15% or more in exchange for debt capital.

Other Forms of Capital: There are actually other forms of capital, such
as vendor financing where a company can sell goods before they have to
pay the bill to the vendor, that can drastically increase return on equity but
don't cost the company anything. This was one of the secrets toSam
Walton's success at Wal-Mart. He was often able to sell Tide detergent
before having to pay the bill to Procter & Gamble, in effect, using PG's
money to grow his retailer. In the case of an insurance company, the
policyholder "float" represents money that doesn't belong to the firm but that
it gets to use and earn an investment on until it has to pay it out for accidents
or medical bills, in the case of an auto insurer. The cost of other forms of
capital in the capital structure varies greatly on a case-by-case basis and
often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle class individuals believe that the goal in life is to be debt-free
(seeShould I Pay Off My Debt Or Invest? ). When you reach the upper
echelons of finance, however, that idea is almost anathema. Many of the most
successful companies in the world base their capital structure on one simple
consideration: the cost of capital. If you can borrow money at 7% for 30 years
in a world of 3% inflation and reinvest it in core operations at 15%, you would
be wise to consider at least 40% to 50% in debt capital in your overall capital
structure.
Of course, how much debt you take on comes down to how secure the revenues your
business generates are - if you sell an indispensable product that people simply must

have, the debt will be much lower risk than if you operate a theme park in a tourist
town at the height of a boom market. Again, this is where managerial talent,
experience, and wisdom comes into play. The great managers have a knack for
consistently lowering theirweighted average cost of capital by increasing productivity,
seeking out higher return products, and more.
To truly understand the idea of capital structure, you need to take a few moments to
readReturn on Equity: The DuPont Model to understand how the capital structure
represents one of the three components in determining the rate of return a company
will earn on the money its owners have invested in it. Whether you own a doughnut
shop or are considering investing in publicly traded stocks, it's knowledge you simply
must have.
http://beginnersinvest.about.com/od/financialratio/a/capital-structure.htm
Capital Structure Overview
Capital structure refers to the way a corporation finances its assets through some combination of equity,
debt, or hybrid securities. A firm's capital structure is the composition or 'structure' of its liabilities. For
example, a firm that sells 20 billion dollars in equity and 80 billion dollars in debt is said to be 20% equityfinanced 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.
Gearing Ratio is the proportion of the capital employed by the firm which comes from outside of the
business, such as by taking a short term loan.

Capital Structure.
Capital Structure shows how a company's assets are built out of debt and equity.
Modigliani and Miller created a theory of Capital Structure in a perfect market. There are several
qualifications for a "perfect market":

no transaction or bankruptcy cost

perfect information

firms and individuals can borrow at the same interest rate

no taxes

investment decisions are not affected by financing decisions

Modigliani and Miller made two findings under these conditions:

The value of a company is independent of its capital structure

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
This means, as leverage increases, while the burden of individual risks is shifted between
different investor classes, total risk is conserved and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the
tax deductibility of interest makes debt financing valuable; the cost of capital decreases as the proportion
of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity
at all.
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must
be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing
assumptions made in the M&M model.
Capital Structure Theory

Trade-off theory allows bankruptcy cost to exist. It states that there is an advantage to financing with debt
(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). The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is 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/Equity ratios between industries, but it doesn't explain differences within the
same industry.
Pecking Order Theory tries to capture the costs of asymmetric information. It states that companies
prioritize their sources of financing (from internal financing to issuing shares of equity) according to least
resistance, preferring to raise equity for financing as a last resort. Internal financing is used first. When
that is depleted, debt is issued. When it is no longer sensible to issue any more debt, equity is issued.
This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal
financing when available, while debt is preferred over equity if external financing is required. Thus, the
form of debt a firm chooses can act as a signal of its need for external finance.
The Pecking Order Theory is popularized by Myers (1984), when he argues that equity is a less preferred
means to raise capital because when managers (who are assumed to know better about true condition of
the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued
and managers are taking advantage of this over-valuation. As a result, investors will place a lower value
to the new equity issuance.