9.4 Capital Structure in Practice

Capital structure decisions are crucial for firms, balancing financial flexibility, growth, taxes, and control. Practical considerations include a company's stage, industry dynamics, and market signaling. Industry norms and benchmarking against peers guide these choices, impacting financial ratios and firm valuation.

Real-world examples illustrate diverse approaches. Apple's cash-rich strategy contrasts with Tesla's growth-driven debt, while GE's divestment reduced complexity. These decisions significantly affect key metrics like ROE, WACC, and EPS, ultimately influencing a company's overall value and stock price.

Capital Structure in Practice

Practical considerations for capital structure

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• Firm's financial flexibility enables raising capital in the future and maintaining a good credit rating
• Firm's growth stage and industry dynamics impact capital structure decisions (startup vs. mature company, stable vs. cyclical industry)
• Tax considerations include interest tax shield benefits of debt and potential tax implications for investors
• Ownership and control considerations involve dilution of ownership with equity financing and debt covenants and restrictions
• Signaling effects to the market: debt issuance may signal confidence in future cash flows, while equity issuance may signal overvaluation of stock

Industry norms in capital structure

• Industry average debt-to-equity ratios guide firms to maintain ratios similar to industry peers, as deviating significantly may raise concerns
• Industry-specific risks and characteristics influence capital structure (capital-intensive industries may require higher debt levels, highly competitive industries may favor lower debt levels)
• Benchmarking against successful competitors involves analyzing capital structures of industry leaders and identifying best practices to adapt to the firm's context

Real-world capital structure examples

• Apple's large cash holdings and minimal debt allow for strategic acquisitions and investments and provide financial flexibility during market downturns
• Tesla's high debt levels to fund growth enabled rapid expansion of production capacity but increased financial risk and vulnerability to economic shocks
• General Electric's divestment of GE Capital reduced overall debt levels and financial complexity, allowing focus on core industrial businesses (aviation, power, renewable energy)

Impact of capital structure decisions

• Return on equity (ROE): higher debt levels can amplify ROE in favorable conditions, but excessive debt can lead to financial distress and lower ROE
• Weighted average cost of capital (WACC): optimal capital structure minimizes WACC, and lower WACC increases firm value, all else being equal
• Earnings per share (EPS): debt financing can boost EPS if return on invested capital exceeds interest rate, while equity financing may dilute EPS in the short term
• Firm valuation multiples: debt levels affect enterprise value multiples (EV/EBITDA), and optimal capital structure can maximize firm value and stock price