Capital structure refers to the mix of interest bearingshort and long term debt plus equity funds used by a firm for to acquireassets, fund operation, and make investments. Capital structure differs fromfinancial structure in that it doesn’t take into account non-interest bearingliabilities. On the balance sheet financial structure can be expressed by adding non-interest bearing liabilities andcapital structure together.
The design of a wise capital structure looks to leverageits equity to acquire low-cost debt that allows the business to grow. Byacquiring low-cost debt that has an interest rate lower than the companiesreturn on investment in business expenses. The design of a strong capital structure requires themanager to address two questions:1. The debt maturitycomposition – The mix of short-term and long term debt.
2. The debt equity composition- The mix of debt and equity the firmuses to fund capitalized assets.A key factor in determining the ideal debt maturitycomposition of a business’s capital structure isthe type of assets owned. Firms thathave heavy investments in fixed assets that are anticipated to produce cashflow over many years typically favor long-term debt when raising capital.
Businesses that investheavily in assets expected to produce short lived cash flows tend lean moretowards short-term debt when financing. The optimal capital structure minimizes the businesses costof capital while raising the value of equity. The source of capital that allowsfor financing fixed cost needs to be combined with common equity to find thebalance best suited to the investment marketplace. If the ideal mix can befound, then all things being equal the firm’s common stock price will bemaximized. Managers and investors must be careful to take into account marketconditions and company specific variables when determining the idealcomposition. Taking on excessive debt can make it difficult to make debtpayments while funding operations. However, Issuing too much equity can lead dilutionof stock, and cause share prices to drop. When an investor looks at becoming part of a business’scapital structure they must balance the risk of investing and rate of return.
Investors with least risk can expect the lowest rate of return. Issuers of debttake lest risk than equity holders. If the need to liquidate arises the Debtholders will be paid in whole before equity investors as agreed to in the financingterms. While debt capital is expected to be paid back on a schedule, equity isexpected to remain in the company indefinitely. Equity comes in two forms, preferredstock and common stock.
Issuing common stock to raise capital is typically more expensive to the businessthan preferred stock before preferred stock holders receive will be compensatedbefore common stock holders in bankruptcy proceedings. A useful tool for managers and investors to understand theright mix of corporate structure is the EBIT-EPS chart. EBIT refers to thelevel of earnings before interest and taxes, and EPS stands for the equateearnings per share between different financing points. It measures the cost of acquiringdebt vs the equity earned by the debt. The chart provides a way to visualizethe effects of alternative capital structures on the business leverage.
Toconstruct the EBIT-EPS chart we need to calculate the debt cost and equityearnings for two different Capital Structure options. The point of where thetwo options interest is called the EBIT-EPS indifference point. It identifiesthe EBIT levels at which the EPS will bill be the same regardless of thefinancing plan. At EBIT points in excess of the EBIT indifference level, themore heavily leveraged financing plan will generate a higher EPS. At EBITamounts below the EBIT indifference level indicate a financing plan does nottake advantage of its available leverage.
Amounts above the indifference levelcould signify that the plan is overleveraged leaving investors vulnerable. Understanding Capital Structure is crucial for anybody witha vested interest in a company. The proper Mix of debt and equity variesdepending on the industry and company profile. When deciding on how to raisecapital managers must balance their leverage to ensure obligations can met,while maximizing earnings for equityholders. Investors in a company must manage their risk and potential return toensure they are part of a capital structure that can meet the terms of theirinvestments. Debt issuers typically expect less return in exchange for having amore secure investment, while equity holders expect higher rates of return inexchange for putting their investment in a vulnerable position should thebusiness not be able to meet its financial obligations. Managers and investorsoften use the EBIT-EPT chart when deciding if a particular capital structurewill leave a company with the leverage needed to grow the business whilemeeting financial commitments.