17.1 The Concept of Capital Structure

Companies need money to operate and grow. They can get it through debt, like loans or bonds, or equity, by selling shares. Each method has pros and cons. Debt is often cheaper due to tax benefits, but it comes with fixed payments and risk.

The mix of debt and equity a company uses is its capital structure. This affects its cost of capital, which is the minimum return needed to satisfy investors. Understanding capital structure helps managers make smart investment decisions and balance risk with potential rewards.

Sources of Capital and Capital Structure

Sources of capital on balance sheets

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• Debt financing involves borrowing money from banks or other financial institutions or issuing bonds
  • Coupon payments on bonds are tax-deductible, effectively reducing the cost of debt
  • In the event of bankruptcy, debt holders have priority over equity holders in claims on company assets
• Equity financing involves raising money by issuing common stock or preferred stock
  • Common stock represents ownership in the company but provides no fixed payments to stockholders
  • Preferred stock is a hybrid security with characteristics of both debt and equity, offering fixed dividend payments but no voting rights
• Retained earnings are profits reinvested in the company, avoiding external financing costs

Significance of cost of capital

• Cost of capital represents the minimum return a company must earn on its investments to satisfy its investors, reflecting the opportunity cost of investing in a particular project or company
• Weighted Average Cost of Capital (WACC) calculates the overall cost of capital by considering the proportions and costs of each financing source using the formula: $WACC = w_d r_d (1-t) + w_e r_e$
  • $w_d$: weight of debt
  • $r_d$: cost of debt
  • $t$: corporate tax rate
  • $w_e$: weight of equity
  • $r_e$: cost of equity
• WACC serves as a hurdle rate for investment decisions
  • Projects with returns above the WACC create value for the company (positive NPV)
  • Projects with returns below the WACC destroy value (negative NPV)
• WACC is crucial in capital budgeting decisions, helping managers evaluate potential investments

Analyzing Capital Structure

Analysis of capital structure weights

• Calculate the total value of the company by adding the market value of equity and the market value of debt
• Determine the weight of each financing source
  1. Weight of debt = Market value of debt / Total value of the company
  2. Weight of equity = Market value of equity / Total value of the company
• Interpret the weights to understand the company's capital structure
  • A higher debt weight indicates a more leveraged capital structure, potentially leading to higher financial risk and volatility in earnings but benefiting from the tax shield of debt
  • A higher equity weight indicates a more conservative capital structure, resulting in lower financial risk and more stable earnings but forgoing the tax benefits of debt financing

Impact of Financial Leverage and Agency Costs

• Financial leverage refers to the use of debt to finance a company's operations, which can amplify returns but also increase risk
• Higher leverage can lead to increased agency costs, as conflicts of interest may arise between shareholders and debt holders
• Signaling theory suggests that changes in capital structure can convey information to the market about a company's future prospects