Capital Structure Definition and Capital Structure Theories
Capital structure is a terminology used in the terms of business to indicate the way a business has been financed. The sources of finance for a business comprise of two major things that include the equity finance and debt finance. Some companies rely more on equity for the finance whereas, some rely more on debt. However, the ideal structure of finance is the 50 percent equity finance and 50 percent debt finance. A company that has floated its shares in the market of about $30 million, whereas the liabilities stand to $70 million, the capital structure of the company is to be 30% equity financed and 70% debt financed.
The capital structure is the derivation of the gearing ratio of the company as well that indicates how geared a company is, the higher is the gearing ratio, the riskier is the company.
Capital Structure in Perfect a Market
A perfect market exists where the information received is perfect, the rate of interest for the companies as well as individuals is same, there are no transaction or issuance costs, and any uncertainty never affects the tax and returns on investment. As per Millar and Modigliani theory, the capital structure of a company in a perfect market is based on the following two points:
• The capital structure of the company and the entire worth of the company are both completely independent of each other,
• Cost of equity of a geared and ungeared company remains same and for the financial risk a premium is to be added. It helps sharing the risk among all the investors of all classes making the value of the firm constant.
Capital Structure in Real World
Talking about the perfect markets we say that the capital structure has no relation to the value of the company, however, the case completely takes a round when it comes to the real world. In the real world, the presence of all the imperfections, transaction costs and effects of uncertainties, the capital structure and the value of the company can’t depend upon each other. This has been explained by the two most important theories.
Capital Structure Theories
Pecking Order Theory
This theory takes an account of the fact that the equity is kept as the last resort of finance and the debt is preferred over the equity. As per the theory, the management of the company first considers the availability of internally generated funds, after that raising debt is the choice and lastly the equity takes place. The main reason behind keeping the equity as a last choice is that the raise of equity leads to a negative signal to the investors and the chances are that the investors will consider the business to be overhauled. However, managers prefer avoiding equity finance to raise money.
Trade off Theory
The trade off theory makes the debt finance as a base associated with the benefits and costs and the way benefits decline with the increase in costs. The theory states that the benefits associated with debt finances tend to diminish and the cost associated tends to rise as the debt finance increases. Therefore the company has to make a consideration of the trade-off between the debt and equity when raising finance.