Question

Capital Structure

For a company to exist it needs money or capital. This capital is referred to as the cost of capital. The corporation needs to decide how and in what forms it will raise the capital.

*Describe the term capital structure

* Identify and define each of its components

*Clearly articulate the debt to equity relationship in the capital structure

Answer 1

Capital Structure: The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

The major components that a Capital Structure are: 1) Debt and 2) Equity

1) Debt: Debt is one of the two main ways companies can raise capital in the capital markets. 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.Dedt of a firm is further classified into a) Long term debt and b) Short term debt.

2) Equity: On the other hand, 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.

Debt to Equity relationship:

Both debt and equity can be found on the balance sheet. The assets listed on the balance sheet are purchased with this debt and equity. 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.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by 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 peers.

Furthermore, listed below are the pros and cons of debt and equity seperately.

Pros and cons of equity:

• No interest payments
• No mandatory fixed payments (dividends are discretionary)
• No maturity dates (no capital repayment)
• Has ownership and control over the business
• Has voting rights (typically)
• Has a high implied cost of capital
• Expects a high rate of return (dividends and capital appreciation)
• Has last claim on the firm’s assets in the event of liquidation
• Provides maximum operational flexibility

Pros and cons of debt:

• Has interest payments (typically)
• Has a fixed repayment schedule
• Has first claim on the firm’s assets in the event of liquidation
• Requires covenants and financial performance metrics that must be met
• Contains restrictions on operational flexibility
• Has a lower cost than equity
• Expects a lower rate of return than equity