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Capital Structure, one of the major areas of finance, refers to the composition of the sources finance for a company. All the companies needs finance to build or purchase their assets. If we look at the balance sheet of any company, asset side refers to the investments or the usage of the funds of the company (consisting of fixed assets like plant, property and equipment, current assets and other investments) and the liability side refers to the sources of the funds of the company. The composition of this liability side of the balance sheet is what we refer as capital structure of the company.
The components of the capital structure are equity, debt and other financial instruments (also known as Hybrid securities). Major classification is considered in terms of internal capital (Equity) and external capital (Debts). The capital structure depicts the financial health of any company. There are various ratios to major the long term solvency of a company which essential depends on the capital structure decision making of the finance managers. One of the widely used ratio is Debt-Equity ratio.
Finance academicians have done tremendous amount of research on this area and therefore we have some theories that helps us to take decision on the optimum capital structure of the company. Following are some of the theories which explains the capital structures of modern organisations:
- Trade-off Theory prompts the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
- Pecking Order Theory states that the cost of financing increases with asymmetric information.
- Agency Costs Theory is an economic concept concerning the cost to a given party principal, when the principal chooses or hires an agent to act on its behalf.
- Market Timing Hypothesis is a theory of how firms and corporations in the economy decide whether to finance economic their investment with equity or with debt instruments