capitalization
American Heritage Dictionary:
Top
cap·i·tal·i·za·tion
(kăp'ĭ-tl-ĭ-zā'shən) 
n.
n.
- The practice or act of capitalizing.
- The sum that results from capitalizing.
- The amounts and types of long-term financing used by a firm, including common stock, preferred stock, retained earnings, and long-term debt.
- The total par value or stated value of no-par capital stock issues.
- The use of capital letters in writing or printing.
Barron's Finance & Investment Dictionary:
Top
capitalization
corporation’s financial framework, including long-term debt, preferred stock, and net worth. It is distinguished from financial structure, which includes additional sources of capital such as short-term debt, accounts payable, and other liabilities. It is synonymous with capitalization, although there is some disagreement as to whether capitalization should include long-term loans and mortgages. Analysts look at capital structure in terms of its overall adequacy and its composition as well as in terms of the debtto- equity ratio, called leverage. See also capitalization ratio; par value.
| Capital Stock, Capital Shares | |
| Capital Surplus, Capital Turnover |
Gale Encyclopedia of Small Business:
Top
Capital Structure
Capital structure is a business finance term that describes the proportion of a company's capital, or operating money, that is obtained through debt and equity. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run.
Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms. Capital structure decisions are complex ones that involve weighing a variety of factors. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.
Advantages and Disadvantages of Financing Options
Both debt and equity financing offer small businesses a number of advantages and disadvantages. The key for small business owners is to evaluate their company's particular situation and determine its optimal capital structure. As Eugene F. Brigham explained in Fundamentals of Financial Management, "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."
The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. In contrast to equity financing, the entrepreneurs are able to make key strategic decisions and also to keep and reinvest more company profits. Another advantage of debt financing is that it provides small business owners with a greater degree of financial freedom than equity financing. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors' claim does not end until their stock is sold. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Finally, debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing.
The main disadvantage of debt financing is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult, and most lenders provide severe penalties for late or missed payments. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans.
The main advantage of equity financing for small businesses, which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers primarily seek security, so they usually require the business to have some sort of track record before they will consider making a loan. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners.
The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.
Further Reading:
Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 4th ed. McGraw-Hill, 1991.
Brigham, Eugene F. Fundamentals of Financial Management. 5th ed. Dryden Press, 1989.
Hamilton, Brian. Financing for the Small Business. U.S. Small Business Administration, 1990.
Kochhar, Rahul, and Michael A. Hitt. "Linking Corporate Strategy to Capital Structure." Strategic Management Journal. June 1998.
Lindsey, Jennifer. The Entrepreneur's Guide to Capital. Probus, 1986.
Mishra, Chandra S., and Daniel L. McConaughy. "Founding Family Control and Capital Structure." Entrepreneurship: Theory and Practice. Summer 1999.
Romano, Claudio A., et al. "Capital Structure Decision Making: A Model for Family Business." Journal of Business Venturing. May 2001.
See also: Debt Financing; Equity Financing
Roget's Thesaurus:
Top
capitalization
noun
- Money or property used to produce more wealth: backing, capital, financing, funding, grubstake, stake, subsidization. See help/harm/harmless, money.
Barron's Law Dictionary:
Top
capitalization
1. for accounting purposes, the allocation of an item of expense to the capital account because of the relatively long life of the asset acquired by the expense. 2.
“[A] method of computation which gives value to land in relation to the income it produces.” 363 N.E. 2d 1018, 1021. 3. The total of long-term capital , such as long-term loans and notes, bonds, mortgages, and stock, used by a business to purchase assets.
Investopedia Financial Dictionary:
Top
Capital Structure
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.
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.
Investopedia Says:
A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Related Links:
Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money! Debt Reckoning
Borrowed funds can mean a leg up for companies, or the boot for investors. Find out how to tell the difference. Will Corporate Debt Drag Your Stock Down?
Learn what it means to do your homework on a company's performance and reporting practices before investing. Advanced Financial Statement Analysis
Find out how analysts determine the fair value of a company with this step-by-step tutorial and learn how to evaluate an investment's attractiveness for yourself. Discounted Cash Flow Analysis
Learn to use the composition of debt and equity to evaluate balance sheet strength. Evaluating A Company's Capital Structure
Random House Word Menu:
Top
categories related to 'capitalization'
- Corporations and Business Practices - capitalization: total funds of corporation, including stocks, bonds, undivided profits, and surplus
- Income Tax - capitalization: transferring cost of certain assets to balance sheet rather than taking full expense in year of purchase
Wikipedia on Answers.com:
Top
Capital structure
"Gearing ratio" redirects here. For the mechanical concept, see gear ratio.
| Finance |
|---|
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. 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. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. 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, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.
|
Contents
|
Capital structure in a perfect market
Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.
Capital structure in the real world
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.
Trade-off theory
Main article: Trade-off theory of capital structure
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.
Pecking order theory
Main article: Pecking Order Theory
Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984)[1] when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.
Agency Costs
There are three types of agency costs which can help explain the relevance of capital structure.
- Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders.
- Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.
- Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.
Structural Corporate Finance
An active area of research in finance is that which tries to translate the models above as well as others into a decision theoretic setups that are time-consistent and that have a dynamic structure similar to the one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment decisions, all have long lived, multi-period implications. Therefore it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in a dynamic structure that approximates reality. A similar type of research is performed under the guise of Credit Risk research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) [2] and Hennessy and Whited (2004)[3].
Other
- The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value.
- Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers.[4]
- Accelerated investment effect—even in absence of agency costs, levered firms use to invest faster because of the existence of default risk.[5]
- Capital structure substitution theory—managements of public companies manipulate capital structure such that earnings per share are maximized.[6]
Capital gearing ratio
Capital gearing ratio = (Capital Bearing Risk) : (Capital not bearing risk)
- Capital bearing risk includes debentures(risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).
- Capital not bearing risk includes equity share capital.
Therefore we can also say,
Capital gearing ratio= (Debentures+Preference share capital) : (Equity shareholders' funds)
Arbitrage
Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage.
A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will converge.
See also
- Capital structure substitution theory
- Cost of capital
- Corporate finance
- Debt overhang
- Discounted cash flow
- Enterprise value
- Financial modeling
- Financial economics
- Pecking Order Theory
- Triple Accounting
- Weighted average cost of capital
Further reading
- Rosenbaum, Joshua; Pearl, Joshua (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-44220-4.
References
- ^ Myers, Stewart C.; Majluf, Nicholas S. (1984). "Corporate financing and investment decisions when firms have information that investors do not have". Journal of Financial Economics 13 (2): 187–221. doi:10.1016/0304-405X(84)90023-0.
- ^ Goldstein, Ju, Leland, (1998)[1]
- ^ Hennessy and Whited (2004)[2]
- ^ Baker, Malcolm P.; Wurgler, Jeffrey (2002). "Market Timing and Capital Structure". Journal of Finance 57 (1): 1–32. doi:10.1111/1540-6261.00414.
- ^ Lyandres, Evgeny and Zhdanov, Alexei,Investment Opportunities and Bankruptcy Prediction(February 2007) Available at SSRN: http://ssrn.com/abstract=946240
- ^ Timmer, Jan (2011). Understanding the Fed Model, Capital Structure, and then Some. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1322703.
External links
- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=778106
- http://www.westga.edu/~bquest/2002/rethinking.htm
- http://www.listedall.com/search/label/capital%20structure
|
|||||||||||||||||||||||||
This entry is from Wikipedia, the leading user-contributed encyclopedia. It may not have been reviewed by professional editors (see full disclaimer)
Post a question - any question - to the WikiAnswers community:
Copyrights:
American Heritage Dictionary
The American Heritage® Dictionary of the English Language, Fourth Edition Copyright © 2007, 2000 by Houghton Mifflin Company. Updated in 2009. Published by Houghton Mifflin Company. All rights reserved.
Read more
Barron's Finance & Investment Dictionary
Dictionary of Finance and Investment Terms. Copyright © 2010 by Barron's Educational Series, Inc. All rights reserved.
Read more
Gale Encyclopedia of Small Business
Encyclopedia of Small Business. Copyright © 2002 by The Gale Group, Inc. All rights reserved.
Read more
Roget's Thesaurus
Roget's II: The New Thesaurus, Third Edition by the Editors of the American Heritage® Dictionary Copyright © 1995 byHoughton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved.
Read more
Barron's Law Dictionary
Law Dictionary. Copyright © 2003 by Barron's Educational Series, Inc. All rights reserved.
Read more
Investopedia Financial Dictionary
Copyright ©2010, Investopedia.com - Owned and Operated by Investopedia US, A Division of ValueClick, Inc. All rights reserved.
Read more
Random House Word Menu
© 2010 Write Brothers Inc. Word Menu is a registered trademark of the Estate of Stephen Glazier.
Write Brothers Inc.
All rights reserved.
Read more
