Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.
Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other investments. There are trade offs firms have to make when they decide whether to raise debt or equity and managers will balance the two try and find the optimal capital structure.
The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
Optimal capital structure
The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in practice, and firms often have a strategic or philosophical view of what the structure should be.
In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue whichever it requires. The new capital that’s issued may be used to invest in new assets or may be used to repurchase debt/equity that’s currently outstanding as a form or recapitalization.
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