While the lifeblood of a company’s financial health and growth is capital and reinvested
capital, the capital structure is the skeleton. In particular, capital structure is the particular combination of debt, equity,
and finance that is used for long term financing (Moneyterms UK, 2007). More importantly, it is the
relative weights of each capital source that makes the capital structure. This term is also called capital gearing which can
also denote the orientation priority of funds that they have.
A company’s capital structure goes a long way in how an executive uses his capital
money at his disposal. The planning method associated with it is called investment appraisal or capital budgeting. A close
look at the net present value equation (NPV) will tell us that the cost of capital or the discount rate is affected by the
cost of debt and the cost of equity. Therefore the composition of debt and equity that form the capital structure is also
part of the cost of capital in a company.
The Modigliani Miller theorem is the first basis of modern thought that can be applied
to capital structure (Wikipedia, 2007). This theorem of capital structure or capital gearing states that in a perfectly competitive
market where there is not tax, no bankruptcy cost, equal information, and an complete market efficiency, the value of the
firm is unaffected by how a firm is financed. Therefore, in a perfectly competitive market, capital structure is independent
of company value. This is called the capital structure irrelevance principle (Wikipedia, 2007). In analogy, the cut of the
cake does not affect how large the cake actually is.
Capital gearing is the measurement of the proportion between debt and equity in a capital
structure. There are different reasons that make the Modigliani Miller theorem untrue in the real world. One of which is the
tradeoff theory of capital structure which states that a tax advantage on debt and the bankruptcy cost of debt is a duality
of tradeoff for the company. The higher the debt a company incurs, the less marginal benefit of further increases decline
while the marginal cost rises. Therefore, a company must have the right tradeoff between tax benefits and debt cost to arrive
at the optimum debt-equity ratio (Wikipedia, 2007)
Another theory that explains the capital structure in the real world is Pecking order theory.
In this theory of capital structure, there is an existence of hierarchy for financing decisions. This hierarchy is governed
by the company’s priorities according to least effort. The hierarchy starts with financing capital through internal
funds, followed by financing through debt, then the use of equity. (Leisz, 2001).
The capital structure of a company as decided by its executive would have to face a number
of questions. A healthy debt and equity ratio may be governed by a tradeoff, or the manager’s intention not to incur
debt or look for external help (Simerly and Mingfang, 2007). In the end, these seemingly deterministic models of capital structure
may not ring true for managers who face limitations on corporate governance policies and philosophies.
References
LIESZ, TJ. (2007). Why Pecking Order Should Be Included in Introductory Finance Courses.
Available: http://www.mountainplains.org/articles/2001/ pedagogy/PECKING%20 ORDER%20THEORY.htm Last accessed 18 October 2007.
SIMERLY, RL and MINGFANG, L. (2007). Thinking the Capital Structure Decision. Available:
http://www.westga.edu/~bquest/2002/rethinking.htm Last accessed 18 October 2007.
Wikipedia. (2007). Modigliani-Miller Theorem. Available: http://en.wikipedia.org/wiki/Modigliani-Miller_theorem.
Last accessed 18 October 2007.
Wikipedia. (2007). Capital Structure. Available: http://en.wikipedia.org/wiki/capital_structure.
Last accessed 18 October 2007.
