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It is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity.
The capital structure is how a firm finances its overall operations and growth by using different sources of
funds.

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A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells
$20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The
firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage.

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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.

Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and
management is attempting to find the perfect capital structure in terms of risk / reward payoff for
shareholders. This is true for Fortune 500 companies and for small business owners trying to determine
how much of their startup money should come from a bank loan without endangering the business.

Let's look at each in detail:

d 0
c : This refers to money put up and owned by the shareholders (owners). Typically,
equity capital consists of two types: 1.) contributed capital, which is the money that was originally
invested in the business in exchange for shares of stock or ownership and 2.) retained earnings, which
represents profits from past years that have been kept by the company and used to strengthen
the balance sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company can utilize because
its "cost" is the return the firm must earn to attract investment. A speculative mining company that is
looking for silver in a remote region of Africa may require a much higher return on equity to get
investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from
toothpaste and shampoo to detergent and beauty products.

d c : The debt capital in a company's capital structure refers to borrowed money that is at
work in the business. The safest type is generally considered long-termbonds because the company
has years, if not decades, to come up with the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-
Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to
meet day-to-day working capital requirements such aspayroll and utility bills. The cost of debt capital in
the capital structure depends on the health of the company's balance sheet - a triple AAA rated firm is
going to be able to borrow at extremely low rates versus a speculative company with tons of debt,
which may have to pay 15% or more in exchange for debt capital.
d r
ccc : There are actually other forms of capital, such as vendor financing where a
company can sell goods before they have to pay the bill to the vendor, that can drastically increase
return on equity but don't cost the company anything. This was one of the secrets to Sam Walton's
success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter &
Gamble, in effect, using PG's money to grow his retailer. In the case of an insurance company, the
policyholder "float" represents money that doesn't belong to the firm but that it gets to use and earn an
investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The
cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often
comes down to the talent and discipline of managers.

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Many middle class individuals believe that the goal in life is to be debt-free (see Should I Pay Off My Debt
Or Invest?). When you reach the upper echelons of finance, however, that idea is almost anathema.
Many of the most successful companies in the world base their capital structure on one simple
consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation
and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt
capital in your overall capital structure.

Of course, how much debt you take on comes down to how secure the revenues your business generates
are - if you sell an indispensable product that people simply must have, the debt will be much lower risk
than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where
managerial talent, experience, and wisdom come into play. The great managers have a knack for
consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher
return products, and more.

There are different theories which govern the relationship between Capital Structure, Cost of Capital and
Valuation of a Company. According to one school of thought there is a relationship between the value of
the firm and its overall cost of capital whereas according to another school of thought, there is no
relationship between the value of the firm and its overall cost of capital. There are four approaches which
govern relationship between the value of the firm and its capital structure. These approaches are :

a) Net Income Approach

b) Net Operating Income Approach
c) Modigilliani-Miller Approach
d) Traditional Approach

These approaches have been explained in detail.

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This approach has been suggested by Durand. According to this approach, a firm can increase its value
or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other
words, if the degree of financial leverage increases the Weighted Average Cost of Capital will decline with
every increase in the debt content in total funds employed, while the value of firm will increase. Reverse
will happen in a converse situation.

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(i) There are no corporate taxes

(ii) The cost of debt is less than cost of equity or equity capitalization rate.

(iii) The use of debt content does not change at risk perception of investors as a result both the kd (debt
capitalization rate) and kc (equity-capitalization rate) remains constant.

The value of the firm on the basis of Net Income Approach can be ascertained as follows:

V=S+D

where, V = Value of the firm

S = Market value of equity

D = Market value of debt

Market value of equity (S) = NI/Kc

where, NI = Earnings available for equity shareholders.

Kc = Equity Capitalization rate

Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of
capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimizing the
cost of capital. The N.I. Approach can be illustrated with help of the following example.

The overall cost of capital under this approach is:

Overall cost of capital = (E.B.I.T.)/(Value of the firm)

Net Income Approachc

According to the Net Income (NI) Approach, suggested by the Durand, the capital structure decision is
relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a
corresponding change in the overall cost of capital as well as the total value of the firm. If, therefore, the
degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average
cost of capital will decline, while the value of the firm as well as the market price of ordinary shares will
increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and
a decline both in the value of the firm as well as the market price of equity shares.
The NI Approach to valuation is based on three assumptions: first, there are no taxes; second, that the
cost of debt is less than the equity-capitalization rate or the cost of equity; third, that the use of debt does
not change the risk perception of investors. That the financial risk perception of the investors does not
change with the introduction of debt or change in leverage implies that due to change in leverage, there is
no change in either the cost of debt or the cost of equity. The implication of the three assumptions
underlying the NI Approach is that as the degree of leverage increases, the proportion of a cheaper
source of funds, that is, debt in the capital structure increases. As a result, the weighted average of
capital tends to decline, leading to an increase in the total value of the firm. Thus, with the cost of debt
and cost of equity being constant, the increased use of debt (increase in leverage), will magnify the
"shareholder's earnings and, thereby, the market value of the ordinary shares.
The financial leverage is, according to the NI Approach, an important variable to the capital structure of a
firm. With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will
be the one at which value of the firm is the highest and the overall cost of capital is the lowest. At that
structure, the market price per share would be the maximum.
If the firm uses no debt or if the financial leverage is zero, the overall cost of capital will be equal to the
equity-capitalization rate. The weighted average cost of capital will decline and will approach the cost of
debt as the degree of leverage reaches one.