Said structure refers to the amount of debt and / or Capital used by a company to finance its operations and finance its assets. The structure is expressed as a Debt-Capital ratio
Debt and Share Capital
They are used to finance commercial operations, capital expenses, acquisitions and other investments. There are concessions that companies have to make when deciding whether to increase debt or equity and managers balance the two attempts and find the optimal capital.
Optimal Capital Structure
Often defined as the ratio of debt to equity that results in the lowest weighted average cost of capital (WACC) for the business.
Debt and Wealth Dynamics
Investors in debt risk less because they have the first claim on company assets. Equity investors take a higher risk as they only receive the residual value once the debt investors have been repaid
Capital cost
The total cost of capital of a company is a weighted average of the cost of capital and the cost of debt, for which the following formula is used:
WACC = (E / V * Re) + ((D / V * Rd) * (1-T))
Where:
- E = market value of the company's equity D = market value of the debt V = total value of capital E / V = percentage of capital that is equity D / V = percentage of capital that is debt Re = cost of equity Rd = cost of debt T = tax rate
Capital Structure by Industry
Cyclical industries like mining are often unsuitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay debt.
Other industries such as banking and insurance use huge amounts of leverage, and their business models require large amounts of debt.
How to recapitalize a business
A company that decides that it should optimize its capital structure by changing the debt and equity combination has a few options to effect this change:
- Debt and Capital Repurchase MethodsDebt Debt and Capital RepurchaseEmit Debt and Pay a Large Dividend to Capital InvestorsEmit Capital and Pay Off Debts
In the first approach, the company borrows money by issuing debt and then uses all of that capital to buy back shares of its equity investors. This has the effect of increasing the amount of debt and decreasing the amount of equity on the balance sheet.
In the second approach, the company will borrow money (i.e., issue debt) and use that money to pay a single special dividend, which has the effect of reducing the value of the equity by the value of the division. This is another method to increase debt and reduce capital.
In the third approach, the company moves in the opposite direction and issues capital by selling new shares, then takes the money and uses it to pay off the debt. Since capital is more expensive than debt, this approach is undesirable and is often only done when a company is overvalued and desperately needs to reduce its debt.
Debt-Equity Commitments
There are many advantages and disadvantages that business owners and managers should consider when determining their capital structure. Below are some of the tradeoffs to consider.
Pros and cons of equity:
- No interest payments No mandatory fixed payments (dividends are discretionary) No maturity dates (no principal amortization) You own and control the business You have voting rights (typically) You have a high implicit cost of capital Expect a high rate of return (dividends and capital appreciation) You have the latest claim on company assets in the event of liquidation. Provides maximum operational flexibility
Pros and cons of debt:
- Has interest payments (typically) Has a fixed payment schedule. Has first claim on company assets in the event of liquidation. Requires covenants and financial performance metrics that must be adhered to. Contains operating flexibility constraints. Has lower cost than capital Expect a lower rate of return than equity
Conclusion:
It is important to know these concepts, especially if you have a company or if you plan to have one, these concepts will lead us to better understand how the capital structure is shaped, how important it is to take it into account to put it into practice. Personally, it is a very interesting topic which has led me to consolidate several projects on the door, especially so as not to fall into financial problems.
