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Balance Sheets Best Practice

Capital Structure: Perspectives

by John C. Groth

Executive Summary

  • Capital structure reflects the financing strategy and potentially influences the value of a company.

  • The potential value to shareholders of capital structure depends on the tax environment.

  • Understanding the logic of capital structure and the origin of potential value is of import to leaders, strategists, and managers.

  • The greater the business risk, the lower the optimal debt/equity (D/E) ratio.

  • Tax strategy and management should consider capital structure. The higher the expected tax rate, the more important are capital structure decisions and management.


Capital has three forms: human, tangible, and financial. In this article, we focus on how financing choices influence the cost of financial capital and company value. Capital structure focuses on the sources of financial capital. The choice of structure affects firm value in some economies.1

The seminal works of Nobel laureate Franco Modigliani conceived important relationships and issues in capital structure. Subsequently, researchers have nourished the development of capital structure theory and the related literature, and they have influenced practice. Many companies follow the prescriptions of capital structure theory, and create value for stockholders and society.2

We do not have the “perfect” capital markets described by economists, and key factors influence the choice of capital structure. For example, investors are concerned with the potential for, and cost of, bankruptcy. If a company disappoints investors by using too little or too much debt, its stock price will suffer. Understanding exactly how the use of some debt may add to company value is essential to understanding capital structure.

First, we will clarify the meaning of capital structure. Then we will address other issues.

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