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 ModiglianiMiller 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 ModiglianiMiller theorem states that in a
perfect world the modalities in which a company chooses to finance itself does not affect its
value.
However, the real value of the ModiglianiMiller theorem is the real world implications
of it. In the real world, which is far from perfect, negative consequences like bankruptcy costs,
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 Spring '11
 Smith
 Finance, Economics, Corporate Finance, Debt, ModiglianiMiller theorem, Franco Modigliani

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