Capital structure is the combination of various forms of external funds, known as capital, used by a company to finance its overall operations and growth.

There are several ways to measure the efficiency of the capital structure: ROIC (return on invested capital), ROE (return on equity), and ROCE (return on capital employed) (return on capital employed). Metrics help us measure how well and efficiently management uses the company's capital.

But what is the best way to structure the capital? The capital structure of each company will depend on many things, and how they set up that structure will affect many of the decisions the CEO makes to help the company grow.

After all, the CEO's main job is to manage the company's capital. As part of our analysis, we look at how each business makes decisions about its capital, as well as how it uses its capital.

Today, we will:

• Understand capital structure
• Outline optimal capital structure
• Look at ways to figure out optimal capital structure
• Discuss key factors that affect the optimal capital structure

What is the Capital Structure?

In the simplest terms, a company's capital structure is how it uses debt and equity to pay for its operations, and possible growth.

Let's talk a bit about equity and debt.

Equity capital or financing comes from owning shares in a company, which give you a claim on the company's future profits and cash flows. When investors buy shares in a company, like Microsoft, they become part-owners of the company and also add to its equity capital.

Debt capital comes from bonds or loans that the company gives out to get money. In exchange for a coupon or dividend payment and the return of the original loan at a set time, buyers of bonds take on debt.

The equity capital comes from common stock, preferred stock, or earnings that are kept by the company. Short-term debt, such as capital leases, is also a part of the company’s capital structure.

On the balance sheet of the company, we find both debt and equity. On the balance sheet, there is also a list of the company's assets, which could have been bought with either debt or equity. Those assets are key drivers of the company’s growth, whether inventory, accounts receivable, or intangible assets.

Capital structure can be a mix of long-term debt, short-term debt, common stock, and preferred stock. Capital structure analysis looks at how the company chooses to pay for its assets.

Companies may choose short term or long-term debt or a mix of the two.

Debt-to-equity ratio, which compares the debt levels to the equity, and generally, gives a quick insight – a higher ratio, implies that the company uses debt aggressively to finance its growth.

Understanding the best way to design your capital structure

The best capital structure depends on the best mix of debt and equity financing that maximizes the company's growth prospects while reducing or minimizing its costs of capital.

In theory, getting money through debt is the cheaper option. Companies can benefit from debt financing because it can help them save money on taxes. For example, companies can deduct the interest they pay on debt loans. And when interest rates are low, it is easy to get debt and it costs much less. All these things lower the cost of debt, which in turn lowers the cost of capital.

We should also keep in mind that debt lets companies keep control of its ownership, while equity dilutes ownership by letting outsiders buy some shares.

When interest rates are low, like they are right now, equity costs more than debt. But one benefit of equity financing is that you don't have to pay it back or take money out of your earnings to pay interest.

There are different kinds of capital structures, and each one affects the best capital structure and the costs we talked about.

High-leverage companies have a lot of debt, which gives the company more control, but it also makes the company more vulnerable to risk and makes it harder to make money from interest payments.

Low leverage companies have less debt, which helps them make more money because they pay less in interest, but it also dilutes their ownership and costs them more in capital expenses.

The best capital structure helps the company grow the most while keeping its cost of capital to a minimum. The discount rate or hurdle rate is lower when the cost of capital is low. This means that the present value of a company’s future cash flows will be higher if the cost of capital is low.

The CEO's most important job is to use money well. The first job of the CFO (Chief Financial Officer) is to find the best capital structure that maximizes the value of a company while minimizing its costs of capital, or WACC.

There are other ways to look at a company's capital structure, like the debt-to-assets ratio and the net debt-to-EBITDA ratio.

During analysis, it is important to have a clear context: each industry or sector will be different; for example, a company’s capital structure in Automobile sector will vary wildly from a company in the Digital Services.

How to Figure Out the Best Way to Structure Capital?

The best capital structure is the mix of debt and equity that gives the most value while keeping the cost of capital as low as possible.

As we already said, each industry or sector will have a different idea of what is best, so what works for GM might not work for Vodafone and T-Mobile. And Microsoft’s capital structure would never work for Exxon because each business needs different amounts of capital.

Microsoft (with a lesser capital-intensive business) can use cash flows to buy the assets it needs to keep doing what it's doing. Exxon needs to borrow money to buy the long-term assets it needs to make cash flows. For example, one oil rig can cost up to $600 million, and the company may need dozens of them to get to the oil it needs to make its products.

There is no one best structure, and each company, industry, and sector will have a different combination that works best.

You also must think about the company's strategic or philosophical view. For instance, Berkshire Hathaway's Warren Buffett doesn't like to use debt or equity to buy the assets the company needs to run.

Instead, he chooses to use the company's free cash flow or earnings.

Buffett thinks that adding more debt or diluting the company by selling shares is a bad way for Berkshire shareholders to spend their money. They bring in enough cash flow or earnings to be able to allocate capital wisely, without putting the company at risk by taking on more debt or diluting the ownership of shareholders.

The company's capital structure is made up of assets, debt, and equity, but investors need to think about certain investment dynamics when looking at the capital structure.

Investors in debt take on less risk because they are first in line to get their money back if the debt isn't paid or the company goes bankrupt. Because of this, investors in bonds are willing to take lower rates of return. This helps a company’s cost of capital to go down when it issues debt instead of equity.

Investors in stocks take on more risk because stocks are much more volatile, and the short-term return can be less than the long-term return. But expect that the higher returns and higher levels of risk will come with higher costs of capital.

All sectors, industries, and companies will have different options, but within each sector, we can choose to optimize the capital structure to grow at a cost that is prudent.

What factors affect the best way to structure capital?

There are a few key factors that influence Capital structure decisions.

1. Predictability of cash flows: The expected cash flows need to be predictable enough to be able to meet obligations (like interest payments) and pay back any bonds when they mature. In addition to making enough extra money, a company could also grow by investing in projects or products that would bring in more money. Or by giving money back to shareholders through dividends or buying back their shares.

Unpredictable cash flows force companies to find other ways to get money, such as by issuing debt or selling shares

Companies with the best capital structure tend to have higher capital ratios like ROIC or ROE, which lead to higher P/E ratios and higher share prices.

2. Competition: If a company is in an industry with a lot of competition, it may have a capital structure with more equity shares. Their earnings are more likely to go up and down than those of businesses with less competition.

3. Cost of capital: The best mix of factors will determine the best type of capital structure. For example, if a company raises more debt, the cost of capital will go down because the cost of debt is lower, and as the proportion of debt goes up, it helps lower the cost of capital.

But if a company keeps taking on more debt, it will reach a point where it has too much debt and that becomes a risk. This makes both the cost of debt and the cost of equity go up. The perceived risk of default makes volatility go up, which is a key factor in the cost of equity.

4. Stage of the life cycle: A business is more risky when it is in its early stages. In such cases it is often difficult to secure debt as lenders don’t see predictable revenue streams. Moreover, debt has a fixed interest rate, and companies that are growing steadily are better candidates for it. Many startups would go in for Equity due to this reason.

5. Size of the Business: A business's ability to get money depends on its size and scope. Small businesses often have trouble getting long-term loans. Because of the size of their business, lenders are hesitant to give them loans. Even if they get the loans, they have to agree to pay back the money quickly and pay high interest rates. It makes it harder for their business to grow.

6. Risk preferences of Management: The amount of debt and equity in a company's capital structure is also affected by how its management feels about risk. Some managers prefer to raise money in a low-risk way by selling equity shares. Other managers are sure that the company can pay back big loans, so they prefer to take on a higher percentage of long-term debt instruments.

7. Control: A company's leaders can't sell equity shares to raise money if they want outsiders to get involved in how the company works. Equity shareholders can choose the board of directors and dilute the ownership stakes of other owners in the company. Some businesses might prefer to use debt instruments to get money. If the creditors get their loan payments and interest on time, they won't be able to mess with how the business works. But if the company doesn't pay back its loans, the creditors can get rid of the current management and run the business themselves.

8.Taxation Policy: The way the government taxes debt and equity instruments is also a key part of its monetary policy. If the government raises taxes on gains from investing in the stock market, investors may stop buying stocks. In the same way, if the government's policies change the interest rate on bonds and other long-term instruments, it will also affect how companies make decisions.

M&A activity is another thing to think about when it comes to capital structures. When one company buys or merges with another, the capital structure of both companies can change, sometimes in big ways. Mergers and Acquisitions generally require very strict due diligence as there are many incentives for overpayment.

For example, if ABC decides to pay for the purchase of XYZ with its own shares, this will raise ABC’s cost of equity. On the other hand, if ABC had used debt financing, this would have increased debt on the balance sheet.

The acquisition also changes the asset side of the balance sheet by increasing goodwill or intangibles, depending on how the other company is structured. There is also taking on more debt, which needs to be paid off either at the time of purchase or over a longer period.

The return on invested capital (ROIC) goes down when the amount of assets goes up, and the return on equity (ROE) goes down when the amount of equity goes up. Both measures of return help investors figure out how well a company uses its capital or equity to grow. And any company that buys another company runs the risk of lowering its returns compared to its costs.

In general, a company with a bigger the difference between its return on equity and its cost of equity, makes more money. The same thing goes for returns on capital and Capital costs. And bad purchases or ones that cost too much can hurt the company's profits.

Lesson for Investors

Choosing the best capital structure is hard, just like making any other financial decision. But most of the time, management tries to work within a certain range.

They also need to know how the market responds to the different decisions they make.

If a company is doing well, it will try to raise money through debt instead of equity. It is common knowledge that equity financing is mostly resorted to when debt is not easy to get; and decisions to resort to increased equity financing can send bad signals to the market.

You can quickly look at a company's capital structure by using ratios like debt/equity and equity/assets. You can quickly figure out how risky a company is by looking at leverage ratios like debt/equity and debt/assets.

Analyzing a company's capital structure is an important part of doing due diligence and figuring out the best capital structure that maximizes value.

Hope you enjoyed this post on Capital Structure, let me know what you think in the comment section below.