Capital structure
Capital structure is the mix of debt and equity a firm uses to finance its assets. The balance affects financial risk, the cost of capital and, under some theories, the total value of the firm.
FrameworkCapital structure theory
See it move
A firm financed 40% by debt and 60% by equity has a debt-to-equity ratio of about 0.67. Because debt is cheaper after tax, shifting the mix toward more debt initially lowers the weighted average cost of capital. Beyond some point, though, rising financial-distress risk erodes that benefit — the balance the trade-off theory describes.
The formula
Variables
- Total interest-bearing debt (€)
- Total equity (book or market value) (€)
The most common summary measure of a firm's financing mix.
Check yourself
According to the trade-off theory of capital structure, why do firms not simply maximise their use of debt to exploit the interest tax shield?