Capital Structure

Capital structure refers to the manner in which an organization allocates its assets and liabilities in various financial instruments, as well as to the relationship between the organization’s debts and reserves. For example, a corporation’s capital structure might consist of 30 percent assets and 70 percent liabilities, meaning that the leverage of the corporation—the ratio of its debt to its overall base of finance, would be 70 percent. Within this capital structure framework, it is possible to drill down further to reach a greater level of detail. Doing so might show that of the 30 percent assets, 5 percent are in long-term bond investments, 18 percent are in real estate assets, and so on. Given the range of options available to corporations for investing assets and for carrying debt, mapping an organization’s capital structure can be an extremely complex undertaking.

Brief History

Capital structure, as it occurs in the real world, is often best understood by reference to what its role would be in a hypothetical, perfect financial market. In this perfect market, all actors in the marketplace—buyers, sellers, investors, creditors, and so on—would have access to all the information needed to make sound decisions about which transactions to undertake and which to avoid. Furthermore, the perfect financial market has no situational or transactional costs, so there are no taxes to consider, no variations in interest rates, and no barriers to the flow of capital. In such a perfect market, the capital structure used by an organization would be completely irrelevant, because no matter where assets and liabilities were carried, they would be equally accessible to the organization when it needed to draw upon them or modify them—there would be no delays, no regulations, and no fees associated with one capital structure but not another.

According to economic theorists such as Merton Miller and Franco Modigliani, all of the fluctuations and variations that are absent in the perfect financial market are present in the real world’s financial markets, and they are what make decisions regarding capital structure a matter of great importance and urgency to corporations and other institutions. One company might choose to carry a significant amount of its debt in instruments bearing a large amount of risk, while another company might choose instruments carrying lower risk but proportionally lower potential return, as well as less flexibility. Because the market is constantly in flux and perfect information is not available in the real world, it is likely that only one of these approaches will prove to be beneficial. The company that chooses its capital structure poorly may soon find itself out of business.

Overview

Because of the complexity of capital structures, numerous theoretical models have been developed to describe various features and implications of competing structural models. One such theory is the theory of hierarchical debt selection, or more commonly, the pecking order theory. This theory of capital structuring focuses on what steps companies must take to deal with the fact that they have limited information about the marketplace and their competitors. Specifically, the theory concerns what kinds of debt companies are willing to take on and under what circumstances. According to Stewart C. Myers, the main proponent of the pecking order theory, companies display a predictable order of preference when it comes to debt sources. The first preference goes to internal financing, which often entails the transfer of capital from one sector of the organization to another, with a realignment of organizational priorities often being necessary as well. For example, a car manufacturer needing additional financing for its latest model might choose to discontinue its line of motorcycles. Secondary preference is given to funding sources outside the organization that do not involve a transfer of equity in the organization, such as obtaining loans from banks and similar institutions. Only when these first two options are not available will an organization agree to carry debt involving a transfer of equity, as this means selling ownership shares in the company to other marketplace actors.

Pecking order theory assumes that decisions about capital structuring of debt will always be made in this fashion, and therefore, it is possible to estimate the financial status of an organization, as well as the importance it places upon a funding initiative, by looking to the type of funding being explored. This gives observers additional information about the organization, which they can use to inform their own decisions about capital structuring. Thus, if the car manufacturer in the previous example were seen by its competitors to be willing to finance its latest model with equity-based debt, it would be reasonable for the competitors to conclude that the manufacturer was either extremely desperate or firmly convinced of the new model’s chances of great success, since otherwise, a company would ordinarily not take such a course. Armed with this insight, the carmaker’s competitors could then determine how to respond, whether by adopting a more aggressive stance in the marketplace to take advantage of the manufacturer’s weakness, or by exploring alternative markets in the face of the manufacturer’s confident stance.

These examples illustrate that capital structure is a multifaceted conceptual model for understanding the behavior of actors in the financial marketplace. Particular decisions about capital structure are made based on their ability to confer benefits or avoid risks, so they have their own inherent properties. At the same time, they have semantic significance because the adoption of a particular structure sends signals to other actors in the marketplace, potentially affecting their behavior and, ultimately, that of the initial actor as well.

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