Question

Why would companies have different capital structures?

Answer 1

Capital structure can be a mixture of a firm's long-term debt, short-term debt, common equity and preferred equity.

Companies like to issue debt because of the tax advantages. Interest payments are 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 is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner.

Companies that use more debt than equity to finance assets 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/or an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. It is the goal of company management to find the optimal mix of debt and equity, also referred to as the optimal capital structure.