Are you a finance professional? Are you looking forward to playing a leading role in the business domain? If your answer to these questions is a yes, then you need to upskill yourself and acquire knowledge related to crucial business concepts like capital structure in order to help a company maximise its returns. Read on to know the capital structure definition and capital structure theories.
What is Capital Structure?
Capital structure involves the act of balancing the debt and equity financing of a company. Simply put, it refers to the different sources of funds, including equity and debt, that a company uses to finance its operations and investments. It can be calculated using the following formula:
Capital Structure = Debt / (Debt + Equity)
Here, debt refers to the total amount of debt financing, and equity refers to the total amount of equity financing.
Determining an optimal capital structure helps in minimising the overall cost of capital, which can balance the expenses associated with debt and equity financing. Also, a well-defined capital structure offers much-needed financial flexibility to companies that provides them access to different sources of funding depending on their needs and market conditions.
Additionally, financial risk can be managed well by properly structuring debt and equity. Further, a company can reduce its tax liabilities by utilising debt in capital structure. Moreover, maintaining an appropriate capital structure leads to enhancing shareholder value.
A crucial aspect of any organisation, capital structure can influence a company's value, financial performance and the cost of capital. On the other hand, it is influenced by the industry, size, and risk profile of the company.
Case Studies on Capital Structure
Here are some case studies that can help develop a better understanding of capital structure theories.
- A mid-sized industrial company, XYZ Manufacturing opted for a mix of debt and equity while expanding its operations. Its leverage increased by taking on debt and this in turn amplified returns on equity. But, higher leverage is also associated with increased risk. And, the company struggled to meet interest payments when the economy slowed down. It faced financial distress owing to a debt-heavy capital structure during the 2008 financial crisis. To cope, XYZ Manufacturing had to sell assets and renegotiate debt terms.
- A research-driven company, ABC Pharmaceuticals aimed to maximise shareholder value. To achieve this, it needed the optimal debt-to-equity ratio. As debt provides a tax shield due to interest deductions, the company leveraged this advantage by issuing bonds. While too much debt could lead to bankruptcy risk, ABC Pharmaceuticals analysed its cost of debt and equity to find the sweet spot.
- A tech startup, DEF Innovations had a capital requirement for product development. To meet this need, they followed the pecking order theory, which suggests companies prefer
internal funds first, then debt, and finally equity. Until DEF Innovations reached a stable growth phase, the company relied on retained earnings and short-term debt. Later, it considered equity issuance.
- When GHI Retail planned to expand globally, it wondered when to issue debt. The company meticulously monitored interest rates and market conditions, and issued debt when rates were favourable. This move of issuing long-term bonds during a low-interest-rate environment helped the company secure funds for its expansion. GHI Retail considered investor sentiments and capitalised on the demand for corporate bonds during bullish markets.
Conclusion
Influenced by risk appetite, industry dynamics, and market conditions, capital structure decisions are multifaceted. They require thoughtful analysis and strategic alignment. If you want to contribute to shaping a company's financial foundation, then pursuing the Global Senior Leadership Programme Specialisation: Chief Finance Officer course by Indian Institute of Management, Lucknow, can help. Connect with Imarticus Learning for more details.
