essay questions on capital structure

17.1 The Concept of Capital Structure

By the end of this section, you will be able to:

• Distinguish between the two major sources of capital appearing on a balance sheet.
• Explain why there is a cost of capital.
• Calculate the weights in a company’s capital structure.

The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These items the company needs to conduct its operations are assets . They appear on the left-hand side of the balance sheet.

The company has to pay for these assets. The sources of the money the company uses to pay for these assets appear on the right-hand side of the balance sheet. The company’s sources of financing represent its capital . There are two broad types of capital: debt (or borrowing) and equity (or ownership).

Figure 17.2 is a representation of a basic balance sheet. Remember that the two sides of the balance sheet must be Assets = Liabilities  +   Equity Assets = Liabilities  +   Equity . Companies typically finance their assets through equity (selling ownership shares to stockholders) and debt (borrowing money from lenders). The debt that a firm uses is often referred to as financial leverage . The relative proportions of debt and equity that a firm uses in financing its assets is referred to as its capital structure .

Attracting Capital

When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock.

Suppose, for example, that you have $5,000, and you purchase Tesla stock. You could have purchased Apple stock or Disney stock instead. There were many other options, but once you chose Tesla stock, you no longer had the money available for the other options. You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments.

From Tesla’s perspective, this means that the company can only attract your capital if it offers an expected return high enough for you to choose it as the company that will use your money. Providing a return equal to what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets.

Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC) .

The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure. If, for example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like Figure 17.3 .

These weights can be derived from the right-hand side of a market-value-based balance sheet. Recall that accounting-based book values listed on traditional financial statements reflect historical costs. The market-value balance sheet is similar to the accounting balance sheet, but all values are current market values.

Just as the accounting balance sheet must balance, the market-value balance sheet must balance:

This equation reminds us that the values of a company’s debt and equity flow from the market value of the company’s assets.

Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million. Bluebonnet’s debt is trading at 97% of its face value. It has one million shares of stock, which are trading for $15 per share.

First, the market values of the company’s debt and equity must be determined. Bluebonnet’s debt is trading at a discount; its market value is 0.97 × $ 5,000,000 = $ 4,850,000 0.97 × $ 5,000,000 = $ 4,850,000 . The market value of Bluebonnet’s equity equals Number of Shares   ×   Price per Share   =   1,000,000   ×   $ 15   =   $ 15,000,000 Number of Shares   ×   Price per Share   =   1,000,000   ×   $ 15   =   $ 15,000,000 . Thus, the total market value of the company’s capital is $ 4,850,000   +   $ 15,000,000   =   $ 19,850,000 $ 4,850,000   +   $ 15,000,000   =   $ 19,850,000 . The weight of debt in Bluebonnet’s capital structure is $ 4 , 850 , 000 $ 19 , 850 , 000 = 24.4% $ 4 , 850 , 000 $ 19 , 850 , 000 = 24.4% . The weight of equity in its capital structure is $ 15 , 000 , 000 $ 19 , 850 , 000 = 75.6% $ 15 , 000 , 000 $ 19 , 850 , 000 = 75.6% .

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The Capital Structure Model Essay

Before choosing a financing method for the company the capital structure must be considered to ensure that after the investment the company is able to remain solvent. Capital structure is determined by the mixture of long-term debt and equity used by the firm to finance its operations. A company’s capital structure is analyzed together with its cost of capital while considering various types of financial plans to be pursued by the company.

Capital structure determines the Valuation of a company using its cost of common capital. Valuation is concerned with the determination of the value of the company. The value of a firm is important not only to its existing and prospective shareholders but also quite useful when a firm is considering acquiring or merging with another firm as well as obtaining capital.

A capital structure consists of two sources of funds and has certain characteristic differences. These sources are simplified as debt and equity although can be broken into various long-term financing into its debt and equity components including stockholders’ equity, preferred stock, common stock retained earnings, and long-term debts.

• Debt capital includes any type of long-term funds obtained by borrowing. There are various types of long-term debt. It can be secured or unsecured, senior or subordinated, raised by the sale of bonds, or through a negotiated long-term loan. Many large manufacturing firms have more than one type of debt on their books. Probably the most common type of long–term debt instrument is the corporate bond.
• Equity capital consists of the long-term funds provided by the firm’s owners. Unlike borrowed funds that must be repaid at a specified date, equity capital is expected to remain in the firm for an infinite period of time. The three basic sources of equity capital to the firm are preferred stock, common stock, and equity capital differs. Common stock is typically the most expensive.

The capital structure of the company shows how much of the company assets are financed by the company through debt and how much from equity. The company while trying to source for funds must consider the optimal cost that will not affect the capital to structure further each source of capital has its own cost of capital and its effect on the long term sustainability of the firm there are a few constraints that the firm uses in determining the firm capital that will be chosen. The most important aspect is the gearing aspect.

Gearing is an important concept in connection with capital structure. Gearing is said to exist wherever a company is financed partly by debt. The more debt there is, the more highly geared is the company. Debt creates a fixed annual charge against profits in the form of interest payments. This causes a magnification of any fluctuations in the residual profits available to equity holders, i.e. they become riskier. This increase in risk due to gearing is known as financial risk. it is to be distinguished from the commercial risk to which any business, however, financed, is subject.

There are two opposing theories of capital structure and its relationship to the cost of capital. The first of these, the traditional theory, says that, since debt is cheaper than equity, it will pay initially it increases the amount of debt financing used. At some critical point, financial risk will begin to impinge on the cost of equity it will be disadvantageous to expand it further. There is thus a minimum cost combination of debt and equity which should be sought.

The second theory is associated with the names of Modigliani and Miller and asserts that the cost of capital relates to the value of the business as an economic entity and is independent of the method of finance. This theory would imply that the financial manager had no important decision to make regarding capital structure. A company may sometimes find it desirable to reorganize its capital structure. The ways in which this may be done should be noted.

The current capital structure of the company

The table below shows that company reliance on creditor financing is very high and has been fluctuating from 2000 to 2003. At the same time company is building equity finance during the same four years. This increase in equity finance came mostly from an increase in retained earnings of the company. The company paid no dividend to its outside shareholders. Instead, it has decided to reinvest its annual profit into the business instead of relying on outside financing. The decrease in total liabilities seems to be due to an equal decrease in the current liabilities of the company. This decrease in current liabilities of the company, therefore, results in improved current and acid test ratio for the year 2002. The interest coverage ratio is improving.

Financing option 1- equity offering

Financing option 1- debenture offering

I will advise the board to go for option 1 which reduces the reliance on debt capital which is currently on the highest. Financing option 1 will reduce reliance on debt capital which will reduce the risk of bankruptcy or insolvency of the firm. currently, the firm relies on debt to finance its operations. This needs to be reduced to a level but is acceptable by the creditors. An increase in debt will create problems of insolvency and the long-term survival of the firm.

The firm has a more equity capital structure and they want to raise more capital they should consider debt capital so as to reduce the weighted average cost of capital. The current capital structure seems to be very expensive for the firm as they are less equity capital.

• Ghetti A., Terrific introduction to financial management; Amazon, 2008 pg218-223
• Gitman L.J., Principles of Managerial Finance ,1990,Harper and Bow pp.336-350
• Mclaney E. Business Finance Theory And Practice ,2003, Prentice Hall, pp.290-305
• Schlosser M., Business Finance Application , Models And Cases, Prentice hall, 2002,pp. 144-146
• Chicago (A-D)
• Chicago (N-B)

IvyPanda. (2021, October 14). The Capital Structure Model. https://ivypanda.com/essays/the-capital-structure-model/

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Bibliography

IvyPanda . "The Capital Structure Model." October 14, 2021. https://ivypanda.com/essays/the-capital-structure-model/.

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What Is Capital Structure?

Dynamics of debt and equity, optimal capital structure.

• Capital Structure FAQs

The Bottom Line

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Capital Structure Definition, Types, Importance, and Examples

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

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.

Key Takeaways

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any investment.
• The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company's borrowing practices.

Investopedia / Matthew Collins

Both debt and equity can be found on the balance sheet . Company assets , also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings . On the other hand, equity represents a claim by the owner on the future earnings of the company.

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's industry peers.

It is the goal of company management to find the ideal mix of debt and equity, also referred to as the optimal capital structure , to finance operations.

Why Do Different Companies Have Different Capital Structure?

Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity.

How Do Managers Decide on Capital Structure?

Assuming that a company has access to capital (e.g. investors and lenders), they will want to minimize their cost of capital . This can be done using a weighted average cost of capital (WACC) calculation. To calculate WACC the manager or analyst will multiply the cost of each capital component by its proportional weight.

How Do Analysts and Investors Use Capital Structure?

A company with too much debt can be seen as a credit risk. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment.

What Measures Do Analysts and Investors Use to Evaluate Capital Structure?

In addition to the weighted average cost of capital (WACC), several metrics can be used to estimate the suitability of a company's capital structure. Leverage ratios are one group of metrics that are used, such as the debt-to-equity (D/E) ratio or debt ratio.

Capital structure is the specific mix of debt and equity that a company uses to finance its operations and growth. Debt consists of borrowed money that must be repaid, often with interest, while equity represents ownership stakes in the company. The debt-to-equity (D/E) ratio is a commonly used measure of a company's capital structure and can provide insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth.

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Capital Structure Essays

Research proposal topic: an investigation of capital structure in the financial management of the uk food retail sector, an analysis of how corporate governance impacts capital structure decisions, csl limited: report, capital structure essay, popular essay topics.

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