Financial planning is a process of setting objectives, assessing assets and resources, estimating future financial needs, and making

plans to achieve monetary goals. Many elements may be involved in financial planning, including investing, asset allocation, and risk
management. Tax, retirement, and estate planning are typically included as well.
Financial planning plays a starring role in helping individuals get the most out of their money. Careful planning can help individuals
and couples set priorities and work steadily towards long-term goals. It may also provide protection against the unexpected, by
helping individuals prepare for things such as unexpected illness or loss of income.

Financial planning may mean different things to different people. For one person, it may mean planning investments to provide
security during retirement. For another, it may mean planning savings and investments to provide money for a dependent's college
education. Financial planning may even involve making career-related decisions or choosing the right insurance products.
Many individuals choose to use the services of financial planners to help them reach their goals. A financial planner is a professional
who provides advice and guidance for a wide spectrum of financial planning issues. Financial planners may or may not be certified
and offer varied levels of experience.
Though a financial planner may make developing a financial plan easier, hiring one is not at all a necessity. There are many books,
computer programs, and other resources available to help individuals with financial planning. Furthermore, there is a wealth of related
information available on the Internet. The decision to hire a financial planner may depend on many things, including the financial
worth of the individual, his or her goals for the future, and the amount of research the individual is willing to perform.
All too often, people delay planning for the future. They may feel such planning should take a back seat to staying financially afloat
in the present. However, even those living from paycheck to paycheck can benefit from financial planning by creating a budget. A
budget can be used to determine what is actually spent each month and find ways to trim or even eliminate unnecessary or out-of-
control expenditures.

Capital structure
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v•d•e

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid
securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in
equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing,
80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of
sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by
taking a short term loan etc.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital
structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital
structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides
the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the
capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This
analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the
firm.

Contents
[hide]
 • 1 Capital structure in a perfect market
• 2 Capital structure in the real world
○ 2.1 Trade-off theory
○ 2.2 Pecking order theory
○ 2.3 Agency Costs
○ 2.4 Other
• 3 Arbitrage
• 4 See also
• 5 Further reading
• 6 References
• 7 External links

[edit] Capital structure in a perfect market

Main article: Modigliani-Miller theorem
Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the
same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings
under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second
'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added
premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor
classes, total risk is conserved and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest
makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The
optimal structure, then would be to have virtually no equity at all.
[edit] Capital structure in the real world
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance.
The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.
[edit] Trade-off theory
Main article: Trade-off theory of capital structure
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefit
of debts) and that there is a cost of financing with debt (the bankruptcy costs of debt). The marginal benefit of further increases in
debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this
trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E
ratios between industries, but it doesn't explain differences within the same industry.
[edit] Pecking order theory
Main article: Pecking Order Theory
Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing
(from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing
means “of last resort”. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer
sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and
prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean
issuring shares which meant 'bringing external ownership' into the company. Thus, the form of debt a firm chooses can act as a signal
of its need for external finance. The pecking order theory is popularized by Myers (1984)[1] when he argues that equity is a less
preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than
investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of
this over-valuation. As a result, investors will place a lower value to the new equity issuance..
[edit] Agency Costs
There are three types of agency costs which can help explain the relevance of capital structure.
• Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV)
projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders
get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt
holders to share holders.
• Underinvestment problem: If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders
rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the
potential to increase firm value.
• Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through
empire building and perks etc. Increasing leverage imposes financial discipline on management.
[edit] Other
• The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value.
• Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers.[2]
• Accelerated investment effect—even in absence of agency costs, levered firms use to invest faster because of the existence of
default risk.[3]
[edit] Arbitrage
Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage.
A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one 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 convertible and the non-convertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will
converge.

Capital Structure
A company's capital structure refers to its debt level relative to equity on the balance sheet. It is a snapshot of the amount and types of
capital that a firm has access to, and what financing methods it has used to conduct growth initiatives such as research and
development or acquiring assets. The more debt that a firm carries, the more risk it is perceived to carry. An ideal capital structure
represents a balance of debt and equity on a balance sheet.

There are various types of equity and debt that constitute a capital structure. Typically, the components that make up these two asset
classes are bonds, preferred stock, and common stock. Bonds are a form of debt, and include loans that a company takes out with a
financial institution or with investors. Debt is also considered leverage, and when a company has too much debt on its balance sheet,
it is said to be over-levered.
On the equity side, common stock is the amount of shares held by common shareholders. These stockholders own an equity stake in
the business and obtain voting rights for important company events. Preferred shareholders similarly obtain an equity stake in the
business, but are not entitled to vote.
A preferred investor receives ongoing dividend payments from a company's net income, or profits, as do some common shareholders.
Profits that a company does not distribute to shareholders through dividend payments but instead are reserved are known as retained
earnings, and qualify as equity on a company's balance sheet. Any additional capital earned from a stock offering similarly adds to
equity.
Capital structure is what a company relies on to acquire the assets necessary to generate future sales and profits at the firm. In order
for the financial capital structure to work efficiently, it will generate returns from the equity and debt that are higher than the cost of
servicing that debt and equity. Costs associated with servicing debt and equity may include interest and principal payments to
bondholders and dividend payments to shareholders.
Issuing debt tends to be a cheaper form of financing for companies versus equity issuance. Although debt holders are entitled to
ongoing payments tied to a loan, the expectations for returns are not as high as they are for equity investors. This is because equity
holders are taking more of a risk than debt holders. Therefore, the burden is on a company to constantly grow earnings and the stock
price in order to retain equity shareholders. In the event of a bankruptcy, bondholders receive priority for a company's assets over
equity holders.

Cost of capital
Cost of capital is essentially another way to identify the opportunity cost that is associated with a given investment. In other words,
the cost of capital has to do with the amount or rate of return that can be expected on the investment, in comparison to what would be
realized by selling off the investment. Investors routinely consider the cost of capital when projecting the potential profits that may be
made by choosing to invest in a given stock or bond issue.

When an investor chooses to make an investment, there is usually an expectation that two specific events will take place. First, the
investor will recoup the amount of capital initially used to purchase the bonds or stocks involved in the transaction. Thus, there is
anticipation that the investor will not in fact incur a loss as a result of the acquisition. Generally speaking, investors do not invest in
securities that offer little to no hope of recouping the initial investment, as this represents negative opportunity costs and defeats the
purpose for investing.
Along with recouping the initial investment, the typical investor also hopes to earn a return on the securities that are acquired.
Depending on the strategy of the investor, this may include a short period where the investment actually loses money before the
security stabilizes and begins to rise in value. But the ultimate goal is for the investment to generate a positive cost of capital. That is,
the investor seeks to realize a rate of return that not only exceeds the initial cost of acquisition, but also earns the investor a significant
amount of financial rewards that help to compensate for the time and effort put into the investment strategy.
Because the whole point of investing is to make money rather than lose it, investors and brokers will pay close attention to the history
and future potential of a given investment opportunity. By doing so, the chances of realizing a rate of return and thus generating a
positive cost of capital are much better than in cases where no research into the potential of the security takes place.

Trading on the equity

Trading on the equity has to do with making use of borrowed funds to increase or expand the investment of capital. The hope is that
by following this pattern, the return that is realized on the trading will ultimately cover any finance charges associated with borrowing
funds for an investment will be offset and a profit still realized. Trading on the equity is not an unusual means of leveraging finances
in order to position a company to take advantage of emerging markets or opportunities to expand the company’s presence in an
existing market.

As with just about any type of financial investment, going with a trading on the equity approach does carry some degree of risk. For
this reason, companies tend to take the task of borrowing funds very seriously. There is often a great deal of research done in advance
of making the decision to expand the level of capital investment through this strategy.
One key factor in deciding to employ trading on the equity has to do with projections of when and how much return can be
reasonably expected from the expansion project. Ideally, the project has an excellent chance of generating revenue shortly after
implementation. When this is the case, it is often possible for the project to begin covering the interest charges associated with
borrowing the capital shortly after the launch. As months go by, the revenue generated by the project assumes a larger role in
repaying the principle of the debt as well as covering the interest. At some point, the goal is to have the generated revenue exceed
both the applicable interest charges and the principle amount borrowed, making the capital project truly profitable for the company.
Unfortunately, not every trading on the equity effort follows this pattern. Many factors may delay or even prevent the project from
ever reaching its full potential. This can include such factors as changes in public tastes, shifts in the economy that make the project
lose viability, natural disasters, and devaluation of currency on the foreign exchange market.
When a project funded by trading on the equity appears to be failing, the investor has a couple of options open. One is to abandon the
project before any more resources are lost in the effort. While this does nothing to pay off the capital borrowed as part of the strategy,
it does allow the investor to cease losing money and begin to apply available resources to pay off the outstanding debt. A second
option is to take on a partner who is sees potential in the project and is willing to make a long term investment in the hope that the
project will ultimately become profitable once the current economic situation changes.