Capital Structure In finance, the term “capital structure” refers to the way a firm finances its assets. Generally speaking, there are two main forms of capital structure: debt financing and equity financing (Cumming 52; Myers, 83). Each type has its own advantages and disadvantages, and an essential task for the successful manager of a firm is to find an optimal capital structure in terms of risk and reward for stockholders.
When making decisions that affect capital structure, managers must be aware of the impact capital structure has on the firm’s potential for future success, as well as the advantages and sedateness of debt versus equity financing. Debt financing can be defined as when a firm raises capital by selling bonds, bills, or notes to individual and/or institutional investors. These individuals or institutions become creditors and in return for their loan, they receive a promise that the principal and interest on the debt will be repaid.
Banks are the most popular source for debt financing and bank loans are often of great importance in the startup of new firms (Richards 1). There are many advantages to using debt to finance assets, but there are also some disadvantages. One of the greatest advantages of debt financing is that the owner of the firm maintains ownership and control of the business. When an entrepreneur borrows money from an outside source, he or she is obligated to make payments on time. After these payments are made and the full principal and interest have been paid back, the entrepreneur has no further obligations owed to the outside source. Richards 1). Another great advantage of debt financing is tax deduction. These deductions are made possible because in most cases, the principal and interest payments on a business loan are classified as business expenses, and can be deducted from your business income taxes (Richards 1). In other words, the government has a percentage of ownership in your business by the tax rate, and the more of those taxes cut, the more profitable the business will become (Richards 1). The extra cash from tax deductions can be used to increase stockholder wealth. One disadvantage of debt financing is the risk it carries.
If a business is unable to make the repayments on the loan, it will be forced into bankruptcy. Regardless of the success or failure of the business, payments will always have to be made. The enders of debt financing will have first priority to be repaid before any equity investors (Richards 1). If repayment fails and the company is forced into bankruptcy then it is likely that the lender will take cash or collateral. Another disadvantage of debt financing is the possibly high interest rates. Even after the discounted rates and deductions have taken place one can still experience high interest rates.
Also, ones interest rate will vary based on credit rating, personal credit history, and economical conditions (Richards 1). One may encounter very high interest rates if credit history ND economic conditions are unfavorable. Further disadvantages of debt financing include the risk of the negative impact unpaid debt will have on the borrower’s credit rating. Credit scores are important, especially for individual entrepreneurs, because of the effect it has on the opportunity to lend money in the future as well as interest rates on future loans.
A high interest rate is a loss of money, so it is important to keep the credit rating low. Another disadvantage of debt financing is the process of using cash as down payment, or forms of collateral. These will be lost if the business goes anoraks. To make a loan one must put up either cash or collateral. Collateral could be assets such as ones car, home, or other personal property. If a business generates insufficient cash flows by the time the loan payment starts, ones collateral is at stake. Most banks and other lenders will most likely ask for some sort of collateral in case of a default in payments (Richards 1).
Debt financing is risky in the sense that personal property and cash stores can be lost if the business goes bankrupt. Among other types of investments includes an equity loan. This extends ownership position to endue the loan or a note (debt) with an option to convert debt to equity. (Smith) Large companies in needs of significant funds have options other than accumulating debt to do so; instead the company turns to investors. Equity financing consists of issuing shares of the company at a price in exchange for moneys and ownership. This price varies directly as the growth of the firms changes.
The types of equity financing consist of seed financing, 1st round financing, 2nd round financing, mezzanine financing, later stage financing, and M & A financing. The seeding option of equity financing is centered primary amongst venture capital. Venture capital is when active individuals are investing into large firms with high risk. The type of firms they invest in are young and are expecting high returns over an amount of time or called “patient capital” (Venture 2). These investors are also known as “angel investors”(Venture 2) .
With the large amounts of capital that the angel investors contribute also comes large shares of the company, and because of that amount those investors become extremely active in the management of the firm. Parts of management that the individuals may include consist of board participation, strategic planning, governance, and capital structure. The cost that are covered by the angels investor are the start up cost and excess funds that gives the firm leverage to withstand the financial stability of the company. Another type of venture capital would be using private venture capital partnership.
These investors target technology related industries such as computer communications, electronics, genetic engineering, and medical or health fields. With this type of venture capital, which is the largest source of risk capital, and with risk associates with a minimum 30 percent return within one year. For companies getting ready to go to market those firms may choose 1st Round Financing. This option is geared toward research and development. When this form of capital is encouraged this loan takes the form of a convertible bond. Convertible bonds are able to become shares of the company ( Smith 5).
Using another option of financing includes the 2nd Round financing. This form is used when a firm is in the early stage maturity and is looking to go public. Proceeding to the Mezzanine Financing which is a venture capital used to support the Initial Public Offering. When the company matures and is in need to expand their facilities or product lines an option to fund will include the Later Stage Financing. Within this stage the company must be profitable or Just not losing money. The last of the capital options is the M & A financing. Which is when two companies combine resources and if they both survive they become mergers.
No matter which form of capital venture used it gives the necessary funds to expand the company. The advantage of using this form of capital gain allows leverage of not being obligated to repay investors. Also an advantage is the sharing of responsibilities and liabilities associated with the company (Compeller 8). On the oppose side, when the company takes off the firm has to share the airings. The disadvantage of using equity from an investor’s point of view is that the firm has no obligation to repay specific sums at specific milestones (Smith 3).
From the firm’s view the disadvantage of using equity is the demanding obligation of having stockholders with high expecting returns to meet. These funds are used to grow the firm instead of stabilize it as using capital from only debt. The disadvantage of using venture capital is that investors have the last call against company assets. Meaning if the company goes bankrupt and are selling assets then investors are last n line. The motivation of the investors’ demands may include having to satisfy the needs of their managerial involvement.
In some instances the stockholders become board members and are the very individuals that may hire or fire the business managers, the C. E. O. ,and the C. F. O. Of the company. Because of the significant impact capital structure has on a firm’s future outlooks, both business managers and investors need to be able to evaluate how it is composed. In order to diagnose any aspect of a firm’s financial health, analysis in the form of ratio computation is molly used to directly compare a certain aspect of a financial statement to other time periods or other firms within the industry.
The ratios serve as a backbone of analysis and are extremely efficient at providing comparison data. This is important because financial statements taken at face value provide little information on their own. However, by comparing a certain figure to other parameters inside of the same accounting period or over time they may provide some clues as to where the firm is heading. Ratios that are particularly relevant when evaluating the capital structure f the firm are the “Debt Management Ratios”. These ratios help measure the extent to which the firm uses debt versus equity to finance its assets.
The most commonly used ratios include the debt ratio, which simply measures the percentage of total assets financed with debt. The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing and the equity multiplier ratio measures the dollars of assets on the balance sheet for every dollar of equity financing. Other ratios that measure the firm’s ability to meet debt obligations are also relevant in the capital structure decision. All ratios mentioned are easily calculated using information that is readily available on the financial statements.
By comparing these ratios over time, to other firms, or to a set standard, management receive input on the details of the firm’s capital structure. The knowledge acquired from ratio analysis can be very helpful for management as they try to steer the firm toward an optimal capital structure. The management’s choice of capital structure heavily impacts he firm’s sustainability in the long term. As management decides on the level of debt versus equity financing, they must consider the trade-off between examining cash flows to the firm’s stockholders versus the risk of defaulting on debt payments.
When a firm does well, debt magnifies the return to the stockholders and that is one reason that stockholders encourage the use of debt financing. However, the increased risks that come with debt financing are not desirable so equity financing is often seen as a safety cushion that can absorb fluctuations and bring the overall risk down. In order to optimize the return on assets, firms can actively make changes to their capital structure. There are two main factors that determine the decision to make changes in capital structure. Firstly, it is important to assess whether the debt interest payments are actually tax deductible.
Secondly, the effect of increased debt on the firm’s likelihood of going bankrupt or entering into financial distress must be thoroughly analyzed. The optimal capital structure is one that offsets these factors’ marginal effects by making them equal to each other. When they do, the firm’s value is maximized and financing costs are minimized. There are two main ways a firm can go about actually changing its capital structure. Management can actively sells additional claims to capital of one kind and use the proceeds to tire the other kind of claim. This strategy is known as active management.
The alternative is to wait until additional capital is needed and then only sell more of the type of claims that the firm wishes to increase. This is known as passive management. Whether a firm chooses active or passive management depends on several factors. Generally speaking, active management is more costly as it incurs more flotation costs. However, the firm’s growth rate may influence Just how strongly and quickly it wishes to change its capital structure as an optimal capital structure could sometimes outweigh the flotation costs of active management.