Capital Structure Of A Company

2836 Words Mar 21st, 2015 12 Pages
MODERN FINANCE
CAPITAL STRUCTURE
The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Capital structure is the proportion of firm’s value financed with debt. 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. Some companies could be all-equity-financed and have no debt at all, whilst others could have low levels of equity and high levels of debt. The decision on what mixture of equity and debt capital to have is called the financing decision. The financing decision has a direct effect on the weighted average cost of capital (WACC). The WACC is the simple weighted average of the cost of equity and the cost of debt. The weightings are in proportion to the market values of equity and debt; therefore, as the proportions of equity and debt vary, so will the WACC. Therefore as a company changes its capital structure it will automatically result in a change in its WACC.
The trade-off theory of capital structure states that firms have an optimal capital structure. If the costs of adjustment were zero, the firm would have no incentive to deviate from this target and adjustments would be made instantaneously. However, because of market imperfections such as contracting…
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