Capital structure is the mix of debt and equity that a business uses to fund its operations. A firm’s capital structure may contain many components, including the following:
- Common stock
- Multiple classes of preferred stock
- Debt having different terms and maturity dates
- Retained earnings
The precise types of debt and equity included in a firm’s capital structure dictate the cost of capital and the amount of risk that management is willing to take on. For example, management may be willing to use a high proportion of debt financing in order to reduce its cost of capital, but doing so increases the risk of bankruptcy, since the firm is at risk of being unable to fulfill its debt repayment obligations.