Capital Structure in General
Every company needs capital to support its operations. Capital structure is a blend of company’s sources of finance and consists of several types of funding. To be more specific, capital structure is a ratio of short-term, long-term liabilities and equity. Depending on the sources of financing, we can distinguish borrowed (or debt) capital and equity (owner’s capital). Combined they form company’s employed capital. Borrowed capital has two significant advantages. First, interest paid is exempt when calculating profit for tax. Second, lenders receive only fixed income on provided funds and shareholder doesn’t have to share profit with them.
Borrowed funds have disadvantages too. First, the higher is the indebtedness ratio, the riskier is the company and the cost of funding and equity rises. Second, if the company faces harsh times and its operating profit is not sufficient to cover interest expenses, shareholders will have to finance this deficit from their own wealth and if they can’t – the company will be declared bankrupt.
So companies that have unstable income and operating cash flows should limit borrowed capital. On the other side those companies that have more stable cash flows have more freedom in attracting borrowed funds. But there’s still a question if borrowed funds are “better” than equity? If yes – should the company be fully funded by equity? And what’s the optimal ratio of borrowed funds and equity?
The value of any firm is the net present value of its future free cash flows discounted by Weighted Average Cost of Capital (WACC). Change in capital structure will influence risk and cost of each capital structure component as well as on capital cost as a whole. Change in capital structure can also affect free cash flow, therefore influencing CapEx decisions.
To add more, many companies pay dividends which decrease retained earnings and increase the amount of funding company must have to finance its business. So factors affecting capital structure decision of a firm are interrelated with dividend policy.
Capital structure decisions are affected by many factors and as you’ll see determining optimal capital structure is not an exact science. So, even companies in the same industry can have significantly different structures of capital. Let’s take a look on how capital structure influences the risk of its components and briefly explain factors affecting capital structure decision.
Factors affecting Decisions on Capital Structure
Key factors affecting capital structure decision are as follows:
When the company decides to have more equity it should keep in mind the cost of equity capital. There’s a common erroneous conclusion that equity is free of any cost – that’s not true. Let’s not forget about dividends – if the owner is able to get, say, 40% of net income as dividends the cost of capital can easily exceed the cost of borrowed capital. As the best practices show, business development is relying only on reinvesting profits into capital and that reduces some financial risks but decreases the speed of business growth greatly. Attracting borrowed funds (given the right strategy, of course) can significantly increase owner’s income by introducing financial leverage. This is mostly true for small and medium companies which often underuse the capacity of borrowing in their business. Issuing equity capital also isn’t possible without incurring additional floatation costs. These costs include various fees related to underwriting, brokerage, and receiving regulatory approval. Generally, costs of issuing equity capital are more than that for issuing debt.
When equity is received not from existing shareholders (owners) problems of change in control can arise. Issuing new shares to the open market (i.e. in IPO’s or FPO’s) introduce new shareholders who can have a significantly different understanding on how the company should be run and if they have a large stake in the company, corporate conflicts can emerge. If the current owners want to have ultimate control over operations and lack additional funds, issuing equity to new shareholders can be inappropriate and debt is more suitable for financing in such cases.
Various regulatory frameworks often prescribe what proportion of equity a company should have in its capital structure. For example, banks are heavily regulated by central banks and under Basel III capital framework should have no less than 8% of their risk-weighted assets funded by equity capital and subordinated debt. Raising debt also usually imposes various debt covenants that restrict a proportion of debt a company is allowed to have.
Of course, debt is not free either. Interest and fees paid to lenders form cost of debt – the less is the cost the more debt can be used. One advantage of debt already mentioned above is that interest paid is deductible for the purposes of calculating income tax. Therefore, the more debt is used the less is the company’s effective tax rate.
When increasing the share of debt capital, the company should keep in mind rising risks. Several ratios are used by analysts to assess company’s risks coming from debt capital. Interest Coverage Ratio (ICR) shows company’s capacity to service its debt by paying interest and is calculated as a ratio of EBIT to interest expense. The higher is this ratio, the more proportion of debt the company can have. Owners and analysts should also have in mind that this ratio is not sufficient to conclude that company actually has enough cash flows to pay interest. To know that it’s important to understand company’s cash flow position which can tell if interest outstanding can be repaid? Debt Service Coverage Ratio (DSCR) is calculated as net operating income to debt obligations (debt due in one year and interest) and is free from ICR’s limitations.
Finally, each company doesn’t exist in isolation from its industry and rivals so the capital structure of other companies is also important. Companies in one industry produce almost similar products and use similar sources of funding and debt / equity mix. So when making decisions on the capital structure it’s useful to take a look at debt / equity prevalent in a selected industry.
A company goes through a number of stages in its lifecycle and to assess company’s capital, it’s crucial to understand which stage it’s on at the moment. Companies usually attract only equity capital when they start doing business because lack of collateral and credit history gives few options to attract investors. But using borrowed funds helps to speed up business development significantly because accumulating profit is a lengthy process. Such economy in time helps grow company quicker and maximize profit.
In the period of crisis, companies usually develop business continuity plans and return on capital decreases. At this point company attracts more borrowed funds to fulfill its short-term obligations and equity share in capital structure shrinks (which evidenced a crisis in the company).
The company overburdened with debt looks less reliable for counterparties and investors; they can start looking for more attractive opportunities. On the other side, when the share of borrowed funds is too low, a cheaper funding source is not fully utilized which leads to decreased return on capital. The optimal decision on the capital structure will be the one with lowest capital cost. One of the simplest implications of capital structure theory is the so-called traditional approach to capital structure.
To sum up, when reviewing factors affecting capital structure decision of a firm it’s important to remember that equity is characterized by the following:
- simplicity in raising (no approval needed, only owner’s decision)
- high rate of return on invested capital as interest on borrowed funds is not paid
- low risk of losing solvency and therefore lower risk of bankruptcy
- equity is limited so it’s impossible to increase business size significantly
- leverage is not used and total return is less than possible
Borrowed funds (debt) have the following advantages and disadvantages:
- vast amount of capital to be raised (given appropriate collateral or guarantee)
- possibility to develop business fast
- can improve return on capital
- harder to attract because lenders seek their own optimal risk-return ratio
- lower company’s solvency1,2