Capital Structure
Capital Structure
Key Concepts
- 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 the composition or ‘structure’ of its liabilities.
Equity Capital
- Equity Capital is funds generated by the firm from selling shares of stock to investors.
- The benefit of equity capital is that it doesn’t need to be repaid.
- Equity holders have a claim on future earnings, and they have voting rights.
- However, for existing shareholders, every new issuance of equity represents a dilution of their ownership in the company.
Debt Capital
- Debt Capital is the money a company borrows and must repay at a set term and usually with a fixed interest.
- Debt capital can be raised through bank loans, notes payable, or bonds issued to the public.
- Debt can be riskier than equity because if the firm can’t repay its debt, it could go bankrupt. But interest paid on debt is tax deductible.
- Debt doesn’t dilute ownership, it has lower financing cost because lenders take less risk.
Hybrid Securities
- Hybrid Securities combine elements of debt and equity, offering features of both.
- They are flexible securities that fall between debt and equity in the risk/return trade-off.
- Examples of hybrid securities include preference shares and convertible notes.
Optimising Capital Structure
- An ‘Optimal’ capital structure is the mix of equity, debt, and hybrid securities that minimises the company’s cost of capital and maximise the firm’s market value.
- Companies often aim to balance risk and return by optimising their capital structures to meet their varying needs for capital, and to deal with the changing market conditions.
- To assess whether a capital structure is optimal, companies can compare their financial metrics, such as profit margin, return on equity and debt to equity ratios, with other peer businesses.
Influence of Business Life Cycle on Capital Structure
- The stage of a company’s growth or lifecycle significantly influences its capital structure.
- Start-ups and younger companies might have less access to debt markets and therefore rely more heavily on equity financing.
- Established, profitable companies often rely more heavily on debt financing for growth.
- Ultimately, the best capital structure for a company is highly dependent on the nature of its business, its goals, the market in which it operates, and the level of risk it is willing to take on.