2. Introduction to capital structure theory In his private office, just down the hall from his conference room, the Chief Financial Officer (CFO) of Turner Newspaper Group (TNG) is meeting with his newly hired assistant, Richard. CFO Kayla CFO Kayla Before our next meeting with the bankers, let's take a second and make sure that we have a common understanding about the company's capital structure. TNG can potentially have three different capital structures: its current, actual capital structure, a target capital structure, and an optimal capital structure. If we wanted to talk about the observed capital structure at which TNG actually exhibits today or any other specific point in time, we'd be talking about which capital structure, Kayla? We'd be talking about TNG's capital structure. This is the capital structure that TNG is currently exhibiting, and it can differ from its ideal capital structure. Very good. Now, if TNG's current capital structure consists of 35% debt and 65% common equity, then, Kayla, how would we know if we are operating with our optimal capital structure? An optimal capital structure is characterized by two important attributes: First, it minimizes the firm's , and second, it maximizes , which should make our shareholders very happy. Again, that's great! Now, tell me, in general and without talking about TNG in particular, why would a company ever be willing to operate with a capital structure that is not equal to its desired or target capital structure? Well, sir, there are several reasons that I can think of. Let's see. First, a firm may use debt and equity financing that differs from its targeted amounts if its business activities or its industry becomes risky or competitive, and, in general, these changes will allow a firm to increase its reliance on debt financing, everything else remaining constant. Second, the availability of may prompt a company to borrow or issue new shares and thereby deviate from its target capital CFO Kayla Second, the availability of may prompt a company to borrow or issue new shares and thereby deviate from its target capital structure. CFO Kayla, you've passed my first test with flying colors! With this understanding of the theory and some real-world experience, you'll be earning your bonus in no time