Capital structure refers to the mix of interest bearing
short and long term debt plus equity funds used by a firm for to acquire
assets, fund operation, and make investments. Capital structure differs from
financial structure in that it doesn’t take into account non-interest bearing
liabilities. On the balance sheet financial structure can be expressed by adding non-interest bearing liabilities and
capital structure together. The design of a wise capital structure looks to leverage
its equity to acquire low-cost debt that allows the business to grow. By
acquiring low-cost debt that has an interest rate lower than the companies
return on investment in business expenses.
The design of a strong capital structure requires the
manager to address two questions:
1. The debt maturity
composition – The mix of short-term and long term debt.
2. The debt equity composition
– The mix of debt and equity the firm
uses to fund capitalized assets.
A key factor in determining the ideal debt maturity
composition of a business’s capital structure is
the type of assets owned. Firms that
have heavy investments in fixed assets that are anticipated to produce cash
flow over many years typically favor long-term debt when raising capital. Businesses that invest
heavily in assets expected to produce short lived cash flows tend lean more
towards short-term debt when financing.
The optimal capital structure minimizes the businesses cost
of capital while raising the value of equity. The source of capital that allows
for financing fixed cost needs to be combined with common equity to find the
balance best suited to the investment marketplace. If the ideal mix can be
found, then all things being equal the firm’s common stock price will be
maximized. Managers and investors must be careful to take into account market
conditions and company specific variables when determining the ideal
composition. Taking on excessive debt can make it difficult to make debt
payments while funding operations. However, Issuing too much equity can lead dilution
of stock, and cause share prices to drop.
When an investor looks at becoming part of a business’s
capital structure they must balance the risk of investing and rate of return.
Investors with least risk can expect the lowest rate of return. Issuers of debt
take lest risk than equity holders. If the need to liquidate arises the Debt
holders will be paid in whole before equity investors as agreed to in the financing
terms. While debt capital is expected to be paid back on a schedule, equity is
expected to remain in the company indefinitely. Equity comes in two forms, preferred
stock and common stock. Issuing common stock to raise capital is typically more expensive to the business
than preferred stock before preferred stock holders receive will be compensated
before common stock holders in bankruptcy proceedings.
A useful tool for managers and investors to understand the
right mix of corporate structure is the EBIT-EPS chart. EBIT refers to the
level of earnings before interest and taxes, and EPS stands for the equate
earnings per share between different financing points. It measures the cost of acquiring
debt vs the equity earned by the debt. The chart provides a way to visualize
the effects of alternative capital structures on the business leverage. To
construct the EBIT-EPS chart we need to calculate the debt cost and equity
earnings for two different Capital Structure options. The point of where the
two options interest is called the EBIT-EPS indifference point. It identifies
the EBIT levels at which the EPS will bill be the same regardless of the
financing plan. At EBIT points in excess of the EBIT indifference level, the
more heavily leveraged financing plan will generate a higher EPS. At EBIT
amounts below the EBIT indifference level indicate a financing plan does not
take advantage of its available leverage. Amounts above the indifference level
could signify that the plan is overleveraged leaving investors vulnerable.
Understanding Capital Structure is crucial for anybody with
a vested interest in a company. The proper Mix of debt and equity varies
depending on the industry and company profile. When deciding on how to raise
capital managers must balance their leverage to ensure obligations can met,
while maximizing earnings for equity
holders. Investors in a company must manage their risk and potential return to
ensure they are part of a capital structure that can meet the terms of their
investments. Debt issuers typically expect less return in exchange for having a
more secure investment, while equity holders expect higher rates of return in
exchange for putting their investment in a vulnerable position should the
business not be able to meet its financial obligations. Managers and investors
often use the EBIT-EPT chart when deciding if a particular capital structure
will leave a company with the leverage needed to grow the business while
meeting financial commitments.