Capital structure

Definition

Capital structure refers to the way a company finances its overall operations and growth through different sources of funds, primarily equity and debt. A company’s capital structure is crucial because it affects the risk and return for shareholders, influences a company's cost of capital, and plays a key role in determining earnings per share (EPS). The balance between debt and equity financing impacts a company's financial health and its ability to generate profits.

5 Must Know Facts For Your Next Test

1. A company with a higher proportion of debt in its capital structure generally has higher financial risk, as it must meet fixed interest obligations regardless of earnings.
2. Equity financing does not require repayment like debt financing, but it may dilute ownership and control for existing shareholders.
3. Capital structure decisions can significantly affect a company's EPS; optimal leverage can enhance EPS, while excessive debt can reduce it.
4. The choice of capital structure impacts a company's cost of capital; typically, debt is cheaper than equity due to tax deductibility of interest payments.
5. Companies often analyze their capital structure using ratios like debt-to-equity and equity-to-assets to assess financial stability and investment appeal.

Review Questions

• How does capital structure influence a company's earnings per share (EPS) calculations?
  • Capital structure influences EPS calculations by determining how much equity versus debt is used to finance operations. A higher level of debt can lead to greater financial leverage, potentially increasing EPS if the firm can generate returns exceeding the cost of debt. However, excessive debt may increase risk, ultimately impacting net income negatively and therefore reducing EPS. This dynamic shows the importance of finding an optimal balance between debt and equity in the capital structure.
• Evaluate how a company’s choice between debt financing and equity financing impacts its overall risk profile.
  • Choosing between debt and equity financing directly impacts a company's risk profile. Debt financing can enhance returns on equity during profitable times due to tax benefits but increases fixed obligations that must be met regardless of earnings, leading to higher financial risk. In contrast, equity financing provides more flexibility since it doesn't require regular repayments, but it may dilute ownership and control. This trade-off illustrates how different financing options affect both financial stability and risk exposure.
• Assess how changes in market conditions might affect a company’s capital structure decisions and overall financial strategy.
  • Changes in market conditions can significantly influence a company’s capital structure decisions and overall financial strategy. For instance, in a low-interest-rate environment, companies might prefer debt financing due to lower borrowing costs, thus increasing leverage to boost returns on equity. Conversely, during economic downturns or rising interest rates, firms may shift toward equity financing to mitigate risk associated with high debt levels. These strategic adjustments reflect how companies must remain agile in managing their capital structures in response to external economic factors.

Related terms

debt financing: Debt financing is the process of raising capital through the issuance of bonds or borrowing from financial institutions, which must be paid back over time with interest.

equity financing: Equity financing involves raising capital by selling shares of the company, which gives investors ownership in exchange for their investment.

weighted average cost of capital (WACC):

WACC is the average rate of return a company is expected to pay its security holders to finance its assets, reflecting the cost of each component of the capital structure.