Capital Structure

What is Capital Structure?

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure.

Capital structures of firms and industries vary widely. The ideal capital structure is one that provides sufficient capital for efficient and profitable operations, a maximum rate of return to the stockholders at a minimum of financial risk, and a minimum dilution of control.

It is often profitable to increase the proportion of debt in the firm’s capital structure, because borrowed funds may earn more than their interest cost. This is known as “leverage” or “trading on the equity.” In a capital structure of $100,000, for example, of which $50,000 represents bondholders’ investment at an interest rate of 5 percent and $50,000 represents equity, total earnings of $10,000 would represent a return of 10 percent on the total capital invested. The bondholders would receive $2,500 as their 5 percent interest, and the stockholders would receive the remainder, $7,500, for a return of 15 percent on their investment.

The use of financial leverage involves a compromise between liquidity and earning power. Cash flows must be arranged to meet fixed payments on debt; the more sales and profits fluctuate, the more difficult is the task of the financial manager in meeting the cash outflow for interest and debt repayments. Companies with stable sales and profits are therefore more likely to use higher degrees of leverage, resulting in capital structures with 50 to 70 percent senior capital (bonds and preferred stock). On the other hand, manufacturing and retailing companies have volatile earnings and sales and, when possible, use a much lower degree of financial leverage.

How Does Capital Structure Work?

Business leaders need to independently come up with a capital structure that works best for their operation. Should more debt financing be used to protect ownership and earn a higher return? Should more equity financing be used to avoid the risk of excessive debt and bankruptcy? These choices have to be made on a case-by-case basis, at both small businesses and large corporations.

Any type of debt or equity is accounted for the capital structure. For instance, debt includes traditional business loans, but it also includes any supplier credit the business receives.

Both debt and equity come with costs, and these are known as the cost of capital. A simple cost of capital is the interest rate paid on a loan, but all forms of financing have their cost. Equity financing comes at the cost of some ownership stake in the business.

The different kinds of costs of capital make it important for businesses to balance their capital structure. The capital with the lowest costs should, ideally, make up the largest proportion of a business’s capital structure.

In practice, the costs of capital have to be balanced with a capital structure that fits the business model. For instance, a cyclical business may not be able to afford to take on much debt, even if the interest rates pose a lower cost of capital than alternatives like equity financing. If it can’t afford to make the loan payments during the slow periods of its business cycle, the business must instead build a capital structure with other types of financing.

Understanding Capital Structure

Capital structure refers to the specific mix of debt and equity used to finance a company’s assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility. Debt, on the other hand, represents a cheaper, finite-to-maturity capital source that legally obligates the company to fixed, promised cash outflows with the need to refinance at some future date at an unknown cost.

A company’s capital structure is the result of such financing decisions that may be guided by capital structure policies or targets set by management and the board. Capital structure is also the result of such factors as company size and maturity, which influence the financing options a company may have available. Besides equity and debt issuance, capital structure can also be significantly affected by merger and acquisition (M&A) activity, which can be financed by cash, borrowing, share assumption and/or debt assumption in addition to proceeds from divestitures and asset sales. Capital structure is also affected over time by the company’s operations, which might consume or generate cash, and by management decisions regarding dividends and share buybacks.

Since we are considering how a company minimizes its overall cost of capital, the focus here is on the market values of debt and equity. Therefore, capital structure is also affected by changes in the market value of a company’s securities over time, particularly the share price.

We tend to think of capital structure as the result of a conscious decision by management, but it is not that simple. For example, unmanageable debt, or financial distress, can arise because a company’s capital structure policy was too aggressive, but it can also occur because operating results or prospects deteriorate unexpectedly.

This reading reviews some of the key factors affecting capital structure, including the following:

  • Company life cycle: Companies typically evolve over time from cash consumers to cash generators, with decreasing business risk and increasing debt capacity.
  • Cost of capital: From a theoretical perspective, company management seeks to maximize shareholder value and determines an optimal capital structure to minimize the company’s weighted average cost of capital (WACC). “Optimal capital structure” involves a trade-off between the benefits of higher leverage, which include the tax deductibility of interest and the lower cost of debt relative to equity, and the costs of higher leverage, which include higher risk for all capital providers and the potential costs of financial distress.
  • Financing considerations: From a practical perspective, company management may consider several factors in capital structure decisions and the use of leverage.
  • Competing stakeholder interests: In seeking to maximize shareholder value, company management may make capital structure decisions that are not in the interests of other stakeholders, such as debtholders, suppliers, customers, or employees.

What is Equity Capital?

Equity capital is a principal of corporate finance, largely considered to be debt-free capital that can come from a variety of places, such as stock options, savings, company earnings, or even family investments. The different components of equity in company capital structure include:

  • Hybrid Financing: A mix of equity and debt found in publicly traded companies, often bought and sold via brokerage firms.
  • Convertible Equity: Hybrid financing that may be offered via convertible preferred shares that can convert to common shares at a fixed rate.
  • Preferred Equity: Financing based on a degree of ownership interest in a business or company, which has its pros and cons, such as payouts before other stockholders but not including any voting rights.
  • Common Equity: Another form of financing offering ownership interest, although ownership doesn’t happen until after the business or company pays off its debts—which makes it a higher risk.

Contributed Capital

When a company receives an investment in exchange for stock, this is contributed capital. This is often what’s offered to venture capitalists and other first-round investors, such as angel investors. Shareholders may also fall under this category. Companies or business owners often have to relinquish their complete control over their businesses in exchange for this kind of funding.

Retained Earnings

Companies can also use their earnings from previous years to fund their businesses, fuel expansion, or assist with acquisitions. This kind of funding works well for larger businesses with brand recognition, as they don’t have to work as hard to convince investors to support the business by buying stock. But green or start-up businesses will need to show a higher return to entice those same investors.

What is Debt Capital?

Debt capital is money that has been borrowed to help support a business’ capital structure. This money may be borrowed over either short term or longer term periods. How much it costs the company is dictated by their viability; if they’re highly rated and able to borrow with low rates, it looks better for a company than if their risk dictates a higher percentage rate on what they borrow. This is where the company balance sheet becomes key to showcasing their worth to lenders and investors.

The different components of debt in capital structure include:

  • Senior Debt: If a company faces financial trouble or filed for bankruptcy, financing under this category gets paid back first. Senior debt loans tend to have a lower interest rate.
  • Subordinated Debt: These loans aren’t as risk free as senior debt loans, but their higher interest rates mean lenders can make their money back and then some.
  • Mezzanine Debt: A subcategory of subordinated debt, mezzanine debt tends to carry higher interest rates because of their reliance on both equity and debt for funding.
  • Hybrid Financing: Another form of debt that relies on both equity and debt that pays interest or dividends, offers fixed or floating returns, and are bought and sold by brokers.
  • Convertible Debt: This debt that comes in the form of bonds can be converted to equity based on a predetermined amount as decided by the debtor.

Loans or Credit Cards

Countless companies have an origin story with a historical capital structure that includes financing from family members, maxed out credit cards, or both. It may not be the easiest way to build company capital structure, which is why loans or small business funds can be a less complicated option—although the application process may be more involved, requiring a business plan and an outline of expenses.

Long-Term Bonds

This debt is a small business’s dream come true because it only pays interest, and the principal doesn’t have to be paid off for a long time.

Short-Term Commercial Paper

These 24-hour loans can account for billions of dollars borrowed from the capital markets, often used by larger Fortune 500 companies to cover major operating costs.

Vendor Financing

Companies may turn to this form of debt to cover any bills owed to vendors, selling off goods to build their business while satisfying financial partners.

Policy Holder “Float”

Insurance companies rely on this kind of debt to cover costs as needed or sit in an account and earn interest until the debt needs to be repaid.

The Importance of Finding the Right Capital Structure for a Business

Every business has different needs, especially when it comes to capital structure. The cash flow and financial support requirements for an international conglomerate are likely going to be more involved and complicated than that of a mom n’ pop shop. Similarly, the capitalization needs of a company focused on consumer goods, which may carry a lower risk, will vary in comparison to a travel company, where needs and demands ebb and flow with the seasons. But both businesses still need to determine what kind of capital structure is going to help them be successful and meet their goals.

Risk analysis and debt management will also operate differently for business entities versus individual proprietors, which is a key component to determining capital structure development and management. By starting out with a strong foundation that limits liabilities, maximizes cash flow, and keeps an eye on the proportion of debt and retained earnings, businesses can create an optimal capital structure that will support their efforts—and encourage others’ support—for years to come.

Factors Determining Capital Structure

  1. Trading on Equity. The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.
  2. Degree of control. In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
  3. Flexibility of financial plan. In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
  4. Choice of investors. The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
  5. Capital market condition. In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital should consist of share capital generally equity shares.
  6. Period of financing. When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.
  7. Cost of financing. In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
  8. Stability of sales. An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
  9. Sizes of a company. Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Why Do Investors Need To Know A Company’s Capital Structure?

A potential investor, acquirer or service provider needs to know about a company’s debt liabilities or equity structure for a number of reasons. One major reason is to assess their enterprise value or predict the financial impact existing obligations may have on a company later down the line. Understanding a company’s capital structure can also be useful in determining the types of financial services they may need now or in the future. In the case of existing debt, information on the type of debt, its maturity schedules and interest rates can be an additional source of insight.

Why Is Capital Structure Important To Decision Making?

With insight into a company’s capital structure, you can identify likely buyouts, acquisition targets and debt refinancing or recapitalization opportunities. For example, lenders can use information on capital structure to identify underleveraged companies that may be looking to take on more debt. Using details on debt interest rate and soon-to-mature debt, a lender can find public companies that may be a good fit for their services. Information on cost of capital—including weighted-average cost of capital (aka WACC), equity dilution, and EV ratio—can be critical for conducting financial analysis and informing M&A strategy.

Why Does The Source Of Financing Matter When Doing Financial Analysis?

It’s important to understand the sources of a company’s funding, since different sources of debt or equity will have different effects on the cost of capital, which in turn will influence enterprise value. The kinds of debt a company has, as well as the interest rates that accompany that debt, will affect the price a potential acquirer may pay or indicate potential risks about investing in or acquiring that company. As such, it is important to review capital structure information to understand whether a company is more skewed towards debt or equity and identifying those that match the specific optimal capital structure of different investment styles or financial services.

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