Capital structure
Saturday, 23 December 2023 6:15 pm
→ Capital structure refers to the company's balance of debt and equity finance
→ The amount of debt and equity the company holds to fund its business.
→ Does it have more debt or equity? And what it should do to raise more finance?
→ If the bank loan had a greater value than ordinary shares then the WACC would be
closer to the cost of debt
Cost of debt vs cost of equity
- The cost of debt finance should always be lower than equity finance
- This is because debt is cheaper than equity
Equity finance Debt finance
Return Dividends are paid at the directors' Lenders are entitled to interest by
discretion law
On Ordinary shareholders receive any Lenders receive any money before
liquidation money last equity
Required Ke > Kd because equity is a riskier Kd < Ke because debt is a less risky
return investment investment
Tax position Dividend payments are not tax Interest payments are tax
deductible deductible
Finding the optimum capital structure
- A higher debt-to-equity ratio (gearing) should reduce the Weighted Average
- However this is not the case, we need to consider a few factors;
- The company needs to have sufficient cash in the business to pay its interest
payments, and any capital repayments
- If the company does not have this , they will go bankrupt and they will face
liquidity issues.
- We need to always ensure that the optimal capital structure is in place, to do this
we need to ensure that the primary shareholders own the business.
- In order for primary shareholders to own the business they need to have the
greatest stake within the business.
Impact of debt on investors
, Impact of debt on investors
- Debt finance exposes ordinary shareholders to greater levels of financial risk
- If the company introduces debt, there is now going to be an obligation to pay
interest, this eats up profit
- There is now less profits available, and less dividends for shareholders
- The company can face bankruptcy risk with more debt
- If a company has a high gearing ratio, and they want to raise finance through debt
- They might struggle as lenders and banks may deny them a loan, or charge a high
interest rate due to the high risk, and shareholders may not be interested in
buying shares.
- Limited finance will restrict the ability of the company to invest and grow
- Financial risk is the risk involved in the company not having sufficient cash in the
business to meet its debt obligations.
Interest payments Bankruptcy risk Future investment
- These must be - Debt finance - High gearing levels
paid before increases the risk of make it difficult to
dividends bankruptcy raise finance in the
- Interest costs - Shareholders are future
reduce profit paid out last if the - This will restrict the
available for company goes into company's ability to
dividends liquidation grow
Types of systematic risk
- Systematic risk is how the company is affected by economic factors such as
geopolitical factors
Business systematic risk Financial systematic risk
- Market-wide factors may make it - Market-wide factors may make it
difficult for the business to difficult for the business to
generate enough revenue to cover generate enough cash to cover its
its operating cost interest and debt repayments
- The level of risk is typically linked - The level of risk is typically linked
to the type of industry that the to the level of debt that the
business operates in business has taken on
- Financial risk is when the business does not have enough cash to pay off interest
and meet any capital repayments
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