While studying the capital structure of a company, the proportion of short-term debt and long-term debt of the company is considered. The capital structure of a firm most often refers to the debt-to-equity ratio of a firm. This ratio gives a perception of how much the company is risky in terms of investment. The firms that are more strongly financed by debt are considered to be comparatively highly levered and hence are exposed to greater risk.
The capital structures are also referred to as the strategy of a company while financing the company's assets by combining the debt, equity or the hybrid securities. The capital structure of a firm is also often referred to as the structure of the liabilities of the company.
The Modigliani-Miller theorem or also better known as the M&M model, proposed by Merton Miller and Franco Modigliani is believed to construct the modern concept of capital structure. According to this famous theorem the market value of a firm is independent of the way the firm is financed under the assumption that the market is a perfect market.
The reason behind the irrelevance of capital structure in a perfect market is the imperfections existing in the real world. The various theories that attempt to explain these imperfections that are based on the M&M model include the following:
- Trade-off theory
- Agency Costs
- Pecking order theory
- The neutral mutation hypothesis
- Market timing hypothesis
