Mastering Capital Structure

Capital structure determines the mix of external funds (capital) used to finance a business, including shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet.

Too much debt in relation to other sources of capital increases financial leverage, which can increase the risk of the company and reduce its financial flexibility, resulting in a greater cost of capital.

Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company's capital structure.

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.

Once management has decided how much debt should be used in the capital structure, decisions must be made as to the appropriate mix of short-term and long-term debt.

In the event of bankruptcy, the seniority of the capital structure comes into play, with senior debt being paid first.

The Modigliani-Miller theorem argues that, in a perfect market, how a firm is financed is irrelevant to its value.

Trade-off theory of capital structure allows bankruptcy costs to exist as an offset to the benefit of using debt as a tax shield.

Pecking order theory states that companies prioritize their sources of financing, preferring to raise equity as a financing means "of last resort".

Capital structure arbitrageurs seek to profit from differential pricing of various instruments issued by one corporation.