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A company’s capital structure is the combination of funding sources that provide the business with long-term income. Every business uses a different mix of long-term funding sources, but rudimentary capital structure models give financial managers a foundation and direction. Capital structure models include the dependence model, the independence model, moderate models, and the pecking order model.
Basic elements of capital structure models include debt financing and equity financing. Debt financing usually takes the form of loans and bonds and equity financing, also known as investment financing, which includes different types of stocks. Differences in the models of capital structure are based on the potential effects of debt financing on equity financing. The basis of each model is a different theory of debt effects.
Dependence models stem from the theory that equity is always affected by debt financing, and any amount of incurred debt raises the cost of capital. In this model, any net income the company earns is expected to match the total market value of the company’s common stock. This keeps a perfect relationship between income and equity, but, in functioning markets, this perfect relationship almost never exists. Instead, the dependence model may be used as a basis for capital structure.
Similarly, most businesses would not be able to follow the independence model, which theorizes that no amount of debt can affect a company’s equity. For example, a company may issue bonds and use capital from those bonds to pay higher stock dividends. In other models, an increase in sale of stocks would be linked to the increased dividends and increased debt, but this model doesn’t link the earnings back to the debt. The independence model works in other ways, refusing to recognize the negative impact of debt on the company’s ability to raise equity.
Since both the dependence and independence capital structure models are extreme, many businesses use a moderate financial structure. Some companies use a tax shield to guard against the rising costs of debt. Other businesses may use the independence model on a theoretical basis, while keeping a running calculation of the possibility of business failure or bankruptcy due to the debt financing. If the risk becomes too high, the business may switch models or lower its debt.
The pecking order model dictates that a business uses the least expensive ways to raise capital first, slowly moving to more expensive capital if necessary. For example, under the pecking order theory a company might spend equity capital first, then income, then debit capital, if absolutely necessary. Debt capital is raised and spent last because it is often the most expensive form of financing.
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