Capital Structure Concepts Introduction - Financial Management

Introduction of Capital Structure

Capital structure is defined as the amount of permanent short -term debt,1 long-term debt, preferred stock, and common equity used to finance a firm. In contrast, financial structure refers to the amount of total current liabilities, long -term debt, preferred stock, and common equity used to finance a firm. Thus, capital structure is part of the financial structure, representing the permanent sources of the firm’s financing. This chapter deals only with the total permanent sources of a firm’s financing; the decision about what proportions of debt should be long -term and short-term is considered.

To illustrate the capital structure concept, suppose that Baker Oil Company currently has $10 million in permanent short -term debt, $40 million in long -term debt outstanding, $10 million in preferred stock, and $40 million in common equity (common stock and retained earnings). In this case, Baker’s current capital structure is said to be “50 percent debt, 10 percent preferred stock, and 40 percent common equity.” Thus, the capital structure pertains to the permanent debt, preferred stock, and common equity portion of the balance sheet.

The emphasis of capital structure analysis is on the firm’s long -range target capital structure, that is, the capital structure at which the firm ultimately plans to operate. For most companies, the current and target capital structures are virtually identical, and calculating the target structure is a straightforward process. Occasionally, however, companies find it necessary to change from their current capital structure to a different target. The reasons for such a change may involve a change in the company’s asset mix (and a resulting change in its risk) or an increase in competition that may imply more risk.

For example, in response to increased risk, competition, and deregulation in the electric utility industry, Standard & Poor’s, a bond rating agency, reduced the desired proportion of debt in the capital structure of an AA -rated utility from a range of 42 to 47 percent to a range of 39 to 46 percent. As a consequence, many utilities have moved toward more conservative capital structures. This chapter examines some of the basic concepts used in determining a firm’s optimal capital structure. The following chapter develops a number of tools of analysis that can assist managers in making actual capital structure decisions.

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