Handbook of Finance: Investment Management and Financial Management

Chapter 60. Capital Structure Decisions in Corporate Finance

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance and Department Head of Finance and Business Law, James Madison University

Abstract: A business invests in new plant and equipment to generate additional revenues and income—the basis for its growth. One way to pay for investments is to generate capital from the company's operations. Earnings generated by the company belong to the owners and can either be paid to them—in the form of cash dividends—or plowed back into the company. The owners' investment in the company is referred to as owners' equity or, simply, equity. If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the value of the company and, hence, enhance the value of their equity. But earnings may not be sufficient to support all profitable investment opportunities. In that case the firm is faced with a decision: forgo profitable investment opportunities or raise additional capital. A firm can raise new capital either by borrowing or by selling additional ownership interests or both. The mix of financing between debt and equity is called the capital structure decision. The capital structure decision affects the risk and the cost of capital of the firm and, hence affects the value of the firm.

Keywords: capital structure decision, debt, equity, financial ...