Capital Structure

Capital Structuring

Within organizations, it sometimes becomes imperative that the firm either use issue debt or equity in order to restructure its capital structure or finance projects to increase shareholder wealth. The term capital structure refers to the mix of debt and equity securities that a firm issues to finance its activities (Graham, Smart & Megginson, 2010). Restructuring a firm's capital structure is referred to as recapitalization and firms that are financed with debt are labeled as levered firms versus unlevered. The managers of an organization practice three main preferences for capital structuring: utilization of retained earnings, borrowing through debt instruments or issue of new shares. Thus the retained earnings, debt and equity constitute the three primary ingredients of the capital structure of the firm. The first two ingredients show ownership by shareholders and the second ingredient shows ownership by means of debt holders.

Using a company's own retained earnings has its advantages and disadvantages within the capital structuring concept. Within the Pecking Order theory, cash is preferred over issuing debt or equity because the firm does not have to give out information and managers can accept positive net present value (NPV) projects without having to risk harming shareholders. Having enough retained earnings in the cash flow statement will allow for what is called financial slack. Financial slack gives managers the ability to internally finance projects and also gives more financial flexibility. According to Billet and Garfinkel (2004), "banks with greater financial flexibility have greater value and devote a smaller percentage of assets to cash and marketable securities. This is consistent with the notion that financial flexibility reduces the sensitivity of firm profits to internal wealth shocks, thus reducing the firm's need to carry financial slack".

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