Capital Structure

Capital structure is the relative proportion of common stock, preferred stock and debt in a business' capital. It is normally expressed as hundred times of the ratio of market value of each component of capital to the sum of the market values of all components of capital.

Capital structure is a statement of the way in which a company's assets are financed. Analysis of capital structure is relevant to understanding the level of risk which a business has. Modigliani and Miller proposed that capital structure is irrelevant when there are no taxes and that 100% debt is the optimal capital structure when there are taxes. However, recent studies suggest that cost of debt falls with increase in the proportion of debt but it leads to an offsetting increase in cost of equity (due to higher distress costs associated with higher debt levels). The optimal structure is where the weighted average cost of capital is lowest and that is anywhere between 100% debt and 100% equity.

Calculation

Percentage of Equity =Market Value of Equity
Market Value of Equity + Market Value of Debt
Percentage of Debt =Market Value of Debt
Market Value of Equity + Market Value of Debt

If market values are not available, the percentages are calculated based on book values.

Capital structure is also expressed by debt to total assets ratio. Percentage of equity and percentage of debt can also be calculated if we know the financial leverage ratio or debt to equity ratio of the business.

Examples

Example 1: Delta Airlines has a recent market capitalization of $9.79 billion whiles the value of the company i.e. the enterprise value is $19.74 billion. The percentage of equity in the company's structure is 49.6% ($9.79 billion/$19.74 billion). The percentage of debt in the capital is 51.4% (1 minus percentage of equity).

Example 2: Calculation of capital structure from financial leverage ratio: Oceanic Airlines has a financial leverage ratio of 2.5. Find its capital structure.

Financial leverage ratio = Total Assets (A) ÷ Total Equity (E) = 2.5

Total Assets (A) ÷ (Total Assets (A) − Total Liabilities (L)) = 2.5

A = 2.5 × (A − L)
A = 2.5 A − 2.5 L
2.5 L = 2.5 A − A
2.5 L = 1.5 A
L/A% = 1.5/2.5 = 60%

Percentage of debt in the capital structure of Oceanic Airlines is 60% which gives us a percentage of equity of 40%.

In the same way we can find capital structure as percentage of equity and percentage of debt from debt to equity ratio.

Written by Obaidullah Jan