Capital Structure in Finance

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The term capital structure in finance is the way a corporation finances its assets through the use of equity, debt, or hybrid securities (Ehrhardt & Brigham, 2009). While equity and debt have long since been well known economic terms, hybrid securities is a relatively new concept. It essentially combines debt and equity and pays a set rate of return or dividend until a preset date, when the owner has a few options such as converting the securities into shares (Wikipedia). Capital structure is then simply the proportion of the corporation's liabilities. For example, if a corporation has $2 billion dollars in equity and $8 billion dollars in debt, the ratio of debt to total financing is 80%, which also means it is 80% leveraged. In reality, there is not only two numbers, but there is a great deal of sources of the debt and equity which yields to the ratio of leverage. Another concept to consider is gearing ratio which refers to the percentage of capital the company uses from outside sources other than the company's own revenue, for example by short term business loans. The Modigliani-Miller theorem, which was created by Franco Modigliani and Merton Miller, was essentially the conceptual framework of modern capital structure. Unfortunately, the theorem relies heavily on disregarding many real life variables, however this does not distract from the main point of the theorem. Basically, the Modigliani-Miller theorem states that in a perfect world the modalities in which a
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