Capital structure, the mixture of a firm's debt and equity, is important because it costs a company money to borrow. Capital structure also matters because of the different tax implications of debt vs. equity and the impact of corporate taxes on a firm's profitability. Firms must be prudent in their borrowing activities to avoid excessive risk and the possibility of financial distress or even bankruptcy.

A firm's debt-to-equity ratio also impacts the firm's borrowing costs and its value to shareholders. The debt-to-equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies tend to have a debt/equity ratio of under 0.5. (Read more in
Spotting Companies In Financial Distress and Debt Ratios: Introduction.) A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt. Issuing new debt increases the debt-to-equity ratio; issuing new equity lowers the debt-to-equity ratio.

As you will recall from Section 13 of this walkthrough, minimizing the weighted average cost of capital (WACC) maximizes the firm's value. This means that the optimal capital structure for a firm is the one that minimizes WACC.

In this section, we'll go into the details of a firm's capital structure, financial leverage, the optimal capital structure and real-world capital structures. We'll also talk about financial distress and bankruptcy, and Modigliani and Miller's ideas about capital structure and firm value when taking corporate taxes into account.

Capital Structure

Related Articles
  1. Investing

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  2. Investing

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  3. Investing

    Debt Reckoning

    Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money!
  4. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  5. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  6. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  7. Investing

    What Is Considered A High Debt-To-Equity Ratio?

    The debt-to-equity ratio divides a firm’s liabilities by its shareholders’ equity to measure its financial leverage.
  8. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors understand how oil and gas firms are managing their debt.
  9. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks.
  10. Small Business

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center