Business Finance · Chapter 5
Study notes aligned to the official NEB syllabus.
Having studied the individual sources of long-term funds, the firm must decide the proportion in which to combine them. This mix of long-term sources is the capital structure, and choosing it well is one of the central financing decisions of the firm. A sensible capital structure keeps the cost of capital low and the value of the firm high without exposing it to unacceptable risk.
Capital structure is the composition of a firm's long-term or permanent sources of finance, namely long-term debt, preferred stock and common equity (including retained earnings). It answers the question of how the firm has financed its long-term assets.
Financial structure is the wider term. It is the composition of the entire right-hand side of the balance sheet, that is all the sources of funds, both long-term and short-term. Financial structure therefore includes capital structure plus current liabilities such as trade creditors and short-term bank loans. The relationship can be written simply:
$$ \text{Financial Structure} = \text{Capital Structure} + \text{Current Liabilities} $$
In other words capital structure is a part of the financial structure. When we drop the short-term liabilities and look only at the permanent financing, we are looking at capital structure.
The optimal capital structure is that particular combination of debt and equity at which the firm's overall cost of capital is at its minimum and, as a result, the market value of the firm is at its maximum. Because debt is cheaper than equity, adding some debt lowers the weighted average cost of capital and raises firm value. But beyond a point the extra debt makes the firm so risky that both lenders and shareholders demand higher returns, which pushes the cost of capital back up. The optimal structure is the balancing point between these two forces.
At the optimal capital structure the firm enjoys the maximum benefit of the cheaper debt while keeping financial risk within safe limits, so the weighted average cost of capital is lowest and the value of the firm, and hence shareholder wealth, is highest. In practice the exact optimum is hard to pinpoint, so managers aim for a sound target range rather than a single perfect ratio.
Having studied the individual sources of long-term funds, the firm must decide the proportion in which to combine them. This mix of long-term sources is the capital structure, and choosing it well is one of the central financing decisions of the firm. A sensible capital structure keeps the cost of capital low and the value of the firm high without exposing it to unacceptable risk.
Capital structure is the composition of a firm's long-term or permanent sources of finance, namely long-term debt, preferred stock and common equity (including retained earnings). It answers the question of how the firm has financed its long-term assets.
Financial structure is the wider term. It is the composition of the entire right-hand side of the balance sheet, that is all the sources of funds, both long-term and short-term. Financial structure therefore includes capital structure plus current liabilities such as trade creditors and short-term bank loans. The relationship can be written simply:
In other words capital structure is a part of the financial structure. When we drop the short-term liabilities and look only at the permanent financing, we are looking at capital structure.
The optimal capital structure is that particular combination of debt and equity at which the firm's overall cost of capital is at its minimum and, as a result, the market value of the firm is at its maximum. Because debt is cheaper than equity, adding some debt lowers the weighted average cost of capital and raises firm value. But beyond a point the extra debt makes the firm so risky that both lenders and shareholders demand higher returns, which pushes the cost of capital back up. The optimal structure is the balancing point between these two forces.
At the optimal capital structure the firm enjoys the maximum benefit of the cheaper debt while keeping financial risk within safe limits, so the weighted average cost of capital is lowest and the value of the firm, and hence shareholder wealth, is highest. In practice the exact optimum is hard to pinpoint, so managers aim for a sound target range rather than a single perfect ratio.