Question

Discuss what is capital structure and why it is important to determine the optimal    level of debt and equity in financing your business.

Answer 1

Capital Structure is the structure of source of funding which is mobilised for a firm / project through various sources of financing - Equity or Debt or Preferred Stock or any other instruments. These sources of financing carry different costs of their own and have their own advantages and disadvantages based on the factors like cost, financial obligations, dilution of ownership, etc.

Based on the below factors, it is important to determine the optimal level of debt and equity to ensure the lowest cost of capital and minimum dilution in the ownership of the entity.

Below is the detailed explanation on the Capital Structure.

Modes of Financing:

For any business, financing is a key aspect to support its operations or key strategic aspects from time to time. These business requirements shall vary in terms of value size, time frame, payback period, risk factors etc. Hence, choosing the right financing choice for the requirement is always necessary. Otherwise, it shall result in the liquidity or excess liquidity related issues.

Short term requirements generally include the operational working capital funding, small capital investments etc

Long term requirements include major capex investments, long term strategic aspects like business expansion plans, business acquisitions, etc

Based on the above, the companies scout for option for funding sources as below:

Equity Financing:

This is the method of raising funds through the issue of equity shares by giving the respective share of ownership on the company. Generally, financing through this source is opted in case of fund requirement for major strategic activities of the company, like Business expansions, business acquisitions, etc. The key advantages and disadvantages as below:

Advantages:

- Long Term: The equity shareholders doesn’t expect an immediate return on/of their investment. They look at long term perspective of the business growth and value addition to their investment. Hence, for the company, there is no immediate obligation to return this money back to shareholder in terms of value or dividends.

- Less risk: The equity shares doesn’t hold any coupon rate or any monthly interest obligations to be paid. The only expectation would be the annual dividend payouts based on the earnings of the company. Hence, the company doesn’t have to worry about the financing cost obligations.

- Cash Flows: To club up the above two, this sourcing provides good support to the Cash Flows of the company with no immediate obligations to pay out;

- Credit Line related issues: If any company’s financial position doesn’t support it to go for external debt, equity shall be the option; However, there are enough due diligence, other business plans etc to be presented before the prospective shareholders to implant confidence on the future operations of the company.

Disadvantages:

- Loss of control: Equity share effectively mean that ownership is shared; Hence there shall be dilution in the ownership on the company. This shall be a case of concern incase of closely held / Promoter Group companies;

- Decision Making: Since equity shareholders are the owners of the company, certain strategic decisions (as per the requirement of the local laws / regulations) need to be taken by the shareholders in their Annual General meetings; This sometimes causes significant delays in decision making and also chances on the conflicts between the shareholders and the management of the company on the vision / strategic plans etc;

- Cost: Unlike a fixed % of cost for debt, equity shareholders expect return on their investment in the form of Dividends. Typically, its like a share from the earnings of the company. Sometimes, this share can be more costly than that of a debt cost;

Debt Financing:

This is the method of raising funds / borrowing funds through various channels like Term loans from financial institutions, issuance of Bonds, Debentures, etc. Generally, financing through this source is opted in both the cases of long term and short term. Various debt instruments available in the market to suit the requirements of the company, The key advantages and disadvantages as below:

Advantages:

- Term: In this case, the term is generally fixed upfront and hence the company shall have complete clarity interms of monitoring the liquidity and further to satisfy debt obligations.

- No control: Unlike equity shares, debt instruments are temporary on the Balance Sheet of the company and they doesn’t own any ownership on the company.To the best, they can have control on certain fixed/current assets of the company which are mortgaged with them.

- Cash Flows: The coupon rates are prefixed in terms of debt and the time frame as well known in advance; This helps in easy monitoring of the funds.

- Tax benefits: The cost of debt can be admitted for tax benefits unlike dividends, which are not tax admissible, for the company.

Disadvantages:

- Creditworthiness: This is a very crucial aspect for any company to have Credit score, ratings and Drawing Power, for it to approach for debt financing.

- Collaterals for the Mortgage: Generally, debt financing need to be supported with a mortgage on the assets of the company. There can be cases, where there shall be requirement of Corporate Guarantees / Personal Guarantees (of Promoters).

- Cost Flows: While one way it is good that the debt obligations are known upfront, any defaults of the payments will have serious repercussions on the debt profile / ratings of the company. The regulatory norms are very strict on these terms.

Preference Shares:

While the above advantages and disadvantages of both equity and debt are analysed, there is another source of funding thru these hybrid instruments – Preference Shares. These are called hybrid as they have the characteristics of both equity as well as debt.

Preference shares as well come in different forms with its own evolution. Unlike equity, Preference share carry dividend % (like a coupon rate for debt) and this rate might be a fixed % or floating %. Also, the preference shares can come as Participating or Non-Participating Preference shares. They can be convertible or non-convertible preference shares. It means that, for a certain period of time, they have the nature of debt and post the same, they turn as equity. They have the blend of both equity and debt in more flexible form and it is up to the company to choose the correct instrument for its funding needs.