In this lesson, you will learn about the effects of capital structure decisions. Specifically, this lesson will cover the following:
1. Capital Structure
Capital structure is the way in which a business elects to finance the assets it needs for operations. The two ways it can do this are as follows:
- Issuing equity, such as common stock shares
- Taking on debt, like bonds or other long-term debt
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EXAMPLE
Suppose a firm has sold $40 billion in equity and $120 billion in debt. We would say that the firm is 25% equity financed and 75% debt financed. This ratio of debt to total financing is also referred to as the firm’s leverage.
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There can also be hybrid securities in the capitalization that have the characteristics of both equity and debt, such as preferred stock.
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- Capital Structure
- The way in which a corporation finances its assets through some combination of equity, debt, and hybrid securities.
2. Cost of Capital
One of the major considerations that overseers of firms must take into account when planning for capital structure is the cost of capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that the capital could be expected to earn on another investment with the same risk.
- For common stock, it is the required return on the stock.
- For bonds, it is the yield to maturity that is discounted for taxes.
Since a company’s securities include both debt and equity, the cost of debt (R
d) and the cost of equity (R
e) are included in the calculation for the cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security and then adds up the results from each security involved in the total capital of the company.
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- Cost of Capital
- The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
3. Leverage
This brings up the question of how much of the capitalization should be equity and how much should be debt. The fact that the debt interest paid is not taxable shows a tendency to favor debt. However, the amount of leverage through debt could increase to the point where risk increases the required rate of return on the debt. So, the decision rests on focusing on this trade-off when choosing how much debt and how much equity should be used in capitalization.
It is reasonable to think that firms use much more debt than they actually do. They don’t use as much debt because of the risk of bankruptcy and the volatility in the credit markets. This volatility increases, particularly when a company tries to take on too much debt.
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- Leverage
- The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).
In this lesson, you learned that the capital structure is the amount of a firm’s total capitalization financed by equity and by debt. Hybrid capitalization can also exist.
You also learned that the cost of capital is one of the main considerations for capital structure. The cost of capital is the rate of return that the capital could be expected to earn on another investment with the same risk; it can be calculated using the weighted average cost of capital.
The amount of debt used by a firm is characterized as its leverage. The cost of this can be reduced because interest payments are tax deductible. The advantage it gives can be lessened if the level of debt becomes too high, thereby raising the associated risk of bankruptcy.
Best of luck in your learning!
