Question

Discuss the two common components of a firm's capital structure. Does a firm need both components? If you were a business owner, which component is most important? Why?

Answer 1

Part 1:

Capital structure of a firm shows how the firm is funding its operations and growth by using various sources of funds. The two common components of a capital structure are debt and equity. Equity holders own a part of a firm and have long term commitment towards the firm. Equity share holders can be of two types, one category includes common share holders and the other category includes preferred shares holders. A company pays regular dividends to preferred shareholders. On the other hand, debt holders are the creditors who lend money to a company. They have no long term commitment to the firm, they are more concerned about timely repayment of their principal amount and the interest. Interest payment on debt is tax deductible. Firms like to issue debt because they also get tax advantage on the interest payments. Unlike equity, debt allows a firm to retain ownership. Cost of debt is less compared to equity because it is secured. In case a company becomes insolvent after incurring big losses, debt holders have the rights to sell the assets of the company and recover the amount which common equity shareholders cannot do.

Part 2:

It is preferred to have a mix of both the components. We do business valuation using weighted average cost of capital or WACC to discount the future cash flows of a company. If WACC is high the present value of future cash flows will be low and vice-versa. So, if present value of future cash flows is low, then the present value of a firm will also less. If present value of a firm becomes less the stock price also minimizes. A best mix of debt and equity maximizes the stock price by minimizing its weighted average cost of capital.

Part 3:

If I were a business owner, I would look for the following questions to choose which among the two components are more important:
1)How soon I need to finance my company?
If I need money faster to fund the the financial needs of my company then I would go for debt. Raising money through equity takes longer time. In this case debt will become more important.

2) Whether I want to sell some part of my ownership in the company to raise money and get an access to investor's knowledge and expertise or I need just money for my business?
If I do not have any issues in selling some part of my ownership in the company to raise money and get an access to investor's knowledge and expertise, then equity will be important for me otherwise debt component.

3)Whether I am owner of a matured company or a startup?
If I am owner of a matured and well established company, I would give more importance to debt because I would have enough money to pay the interest even if my company is running in losses for say 2-3 years. I will get tax benefit and cost of capital will also be less compared to equity. On the contrary, if I am an owner of a startup business, I would prefer equity because in case my company starts operating in losses I won't have enough money to pay to my creditors and they may file case in court and I might have to sell some assets of my company to pay them.