An Introduction to Capital Structure

Definition: The capital structure of a business is the mix of types of debt and equity the company has on its balance sheet. The capital or ownership of a business can be evaluated by knowing how much of the ownership is in debt and how much in equity. The company's debt might include both short-term debt and long-term debt (such as mortgages), and equity, including common stock, preferred shares, and retained earnings. Capital structure is sometimes referred to as a company's debt to equity ratio.

The assets of a company can be financed either by increasing the owners cl ims or the a creditors claims. The owners claim increase when the firm raises funds by issuing ordinary shares or by retaining earnings; the creditors claims increase by borrowing. The various means of financing represent the financial structure of an enterprise. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserve and surplus (retained earnings). The company will have to plan its capital structure initially at the time of its promotion. Subsequently, whenever funds have to be raised finance investment, a capital structure decision is involved. Capital structure refers to the mix of sources from where the long-term funds required in the business may be raised. A demand for raising funds generates a new capital structure a decision has to be made to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors, which will govern the decision at present. The companys policies to retain or distribute earnings affect the owners claim. Shareholders equity position is strengthened by retention of earning. The debt equity mix has implications for the shareholders earnings and risk, which in turn will affect the cost of capital and the market value of the firm. Patterns of the Capital Structure In case of new company, the capital structure may be of any the following patterns:
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Capital Structure with equity shares only. Capital Structure with equity and preference. Capital Structure with equity and debentures. Capital Structure with equity, preference shares and debentures.

Debt is the liability on which interest has to be paid irrespective of the company profits. While equity consists of shareholder or owners funds on which payment of dividend depends upon the companys profit. A high proportion of the debt content in the capital structure increases the risk and may lead to financial insolvency in adverse time. However, raising fund through debt is cheaper as compared to financing through shares. This because figure-3 interest on debt is allowed as an expense for taxes purpose. Dividend is considered to

be an appropriation of profits; hence payment on dividend does not result in any tax benefit to the company. This means if company, is in 50% tax bracket, pays interest at 12% on its debentures, the effective cost to it comes only 6% while if the amount is raised by 12% Preference Shares, the cost of raising the amount would be 12%. Thus raising the funds by borrowing is cheaper resulting in higher availability of profit for shareholders. This increases the earning per share of the company, which is the basic objective of the finance manager.

Optimum Capital Structure A firm should try to maintain an optimum capital structure with a view of to maintain financial stability. The optimum capital structure is obtained when the market value per equity share is the maximum. It may be defined as that relationship of debt and equity securities which maximizes the value of a companys share in the stock exchange. In case a company borrows and this borrowing helps in increasing the value of companys share in the stock exchange, it can be said that the borrowing has helped the company in moving towards its optimum capital structure. In case, the borrowing results in fall in market value of the companys equity shares, it can be said that the borrowing has moved the company from its optimum capital structure. The objective of the firm should therefore be to select the financing or debt equity mix, which will lead to maximum value of the firm. Consideration The following consideration will greatly help a finance manager in achieving his goal of optimum capital structure:
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Take advantage of favourable financial leverage. Take advantage of the leverage offered by the corporate taxes. Avoid a perceived high risk capital structure.

Capital Structure - What It Is and Why It Matters The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. This is true for Fortune 500 companies and for small business owners trying to determine how much of their startup money should come from a bank loan without endangering the business.

Let's look at each in detail:

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Equity Capital: This refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: 1.) contributed capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership and 2.) retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.

Many consider equity capital to be the most expensive type of capital a company can utilize because its "cost" is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.
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Debt Capital: The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bonds because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime.

Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. The cost of debt capital in the capital structure depends on the health of the company's balance sheet - a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.

Other Forms of Capital: There are actually other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can drastically increase return on equity but don't cost the company anything. This was one of the secrets to Sam Walton's success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in effect, using PG's money to grow his retailer. In the case of an insurance company, the policyholder "float" represents money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure Many middle class individuals believe that the goal in life is to be debt-free (see Should I Pay Off My Debt Or Invest?). When you reach the upper echelons of finance, however, that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure.

Of course, how much debt you take on comes down to how secure the revenues your business generates are - if you sell an indispensable product that people simply must have, the debt will be much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom comes into play. The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher return products, and more. To truly understand the idea of capital structure, you need to take a few moments to read Return on Equity: The DuPont Model to understand how the capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing i
n publicly traded stocks, it's knowledge you simply must have.