Capital Structure
In finance, capital structure refers to the way a corporation finances its assets via some combination of debt, equity or sometimes hybrid securities. A business firm's capital structure is then the makeup of its financial obligation. Gearing Ratio is the proportion of the capital employed of the business firm which come from outside of the business finance, example by taking a short term loan etc.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, In spite of the fact that it is in general viewed as a purely theoretical result since it disregards many crucial factors in the capital structure decision. The theory states that, in a perfect market, how a business firm is financed is irrelevant to its value. This result provides the base with which to examine real world grounds why capital structure is to the point, that is, a business firm's value is regarded by the capital structure it had employed. Some other reasons comprise agency costs, taxes, bankruptcy costs and information asymmetry. This investigation can then be broadened to look at whether there is in reality an optimal capital structure, the one which attain the most of the value of the business firm.
Capital structure in a perfect market
Consider a perfect capital market, no transaction or bankruptcy costs; perfect information, business firms and individuals can take over at the same interest rate, investment decisions and no taxes are not affected by financing decisions. Modigliani and Miller brought in two determinations under these conditions:
i) The first 'proposition' was that the value of a company is not dependent of its capital structure.
ii) The second 'proposition' stated that the cost of equity for a leveraged business firm is equal to the cost of equity for an unleveraged business firm, with an added premium for financial risk.
That is, as leverage increases, while the burden of individual risks is switched between different investor classes, total risk is preserved and from that fact no extra value produced.
Their analysis was broadened to include the effect of taxes and risky debt. Under a authoritative tax system, the tax deductibility of interest attains debt financing valuable, i.e, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, would be to have almost no equity at all.
Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk)
Capital bearing risk lets in debentures risk is to compensate interest and preference capital risk to pay dividend at fixed rate. Capital not bearing risk lets in equity share capital.
Thus we can also states that:
Capital gearing ratio= (Debentures+Preference share capital) : (Equity shareholders' funds)
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