Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. In order to achieve the firm's goal of owner wealth maximization, the financial manager must be able to assess the firm's capital structure and understand its relationship to risk, return, and value. The term capital denotes the long-term funds of the firm. All the items on the right-hand side of the firm's balance sheet, excluding current liabilities, are sources of capital (Myers, 1994).
Debt CapitalDebt capital includes all long-term borrowing incurred by the firm. The cost of debt was found to be less than the cost of other forms of financing. The relative inexpensiveness of debt capital is because the lenders take the least risk of any long-term contributors of capital. Their risk is less than that of other because (1) they have a higher priority of claim against any earnings or assets available for payment (2) they have a far stronger legal pressure against the company to make payment than do preferred or common stockholders, and (3) the tax-deductibility of interest payments lowers the debt cost to the firm substantially.
Equity capitalEquity capital consists of the long-term funds provided by the firm's owners, the stockholders. Unlike borrowed funds that must be repaid at a specified future date, equity capital is expected to remain in the firm for an indefinite period. The two basic sources of equity capital are (1) preferred stock and (2) common stock equity, which includes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and preferred stock, respectively (Pinegar, Wilbricht, 1989).
A firm's capital structure is determined by the mix of long-term debt and equity it uses in financing its operations. Debt and equity...