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Capital Structure refers to the way a corporation finances itself through some combination of equity sales, equity options, bonds, and loans. Optimal capital structure refers to the particular combination that minimizes the cost of capital while maximizing the stock price.
Is there an optimal capital structure, one that allows a corporation to get the most bang for its bucks? If so, what is that structure and on what factors does it depend? These are important questions for the discipline of financial economics.
Arbitrage
Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage.
A cap-structure arb looks for opportunities created by the differential pricing of different instruments issued by the same 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 convert and the non-convert bonds gets too large, then a cap-structure arb will bet that it will converge.
Alternative Capital Structure Theories
- The Static Trade-off theory - optimal capital structure represents a trade-off between tax benefits of debt and bankruptcy costs
- The managerial incentives theory - optimal capital structure describes the optimal control mechanism for adverse incentives created by too little debt and adverse incentives created by too much debt
- The pecking order hypothesis - optimal capital structure at any time depends on minimum mispricing due to outsiders being less informed than insiders
- The neutral mutation hypothesis - firms fall into different habits of financing which do not impact on value
See also
External links
"Capital structure"