A company’s capital structure is determined by its long-term financing arrangements, including a combination of common stock, debentures, preferred stock, long-term debt, and retained earnings. The capital structure, which is also known as the capitalization structure, differs from the financial structure in that the latter reflects short-term liabilities and accounts payable.
To better understand the nature of a company’s capital structure, it is worth considering the comparative levels of equity and debt. Companies with relatively high levels of debt are said to have higher “gearing.” However, a company’s gearing outlook is not always as simple as it may appear at first glance. Convertible bonds, for example, are classed as debt at the time of issue but could subsequently become equity. Conversely, preference shares are by nature equity, but they have a fixed-return element that gives them certain debt-like characteristics.
At a simplistic level, a company’s choice of capital structure should have no impact on the company’s total value, as represented by the sum of equity and debt. This theory is sometimes known as “capital structure irrelevance” or the “Modigliani–Miller theory.” Promulgated in the 1960s by Franco Modigliani and Merton Miller, who later collected the Nobel Prize for Economics, the basis of the theory is that all investors in the company ultimately benefit from the total cash flows enjoyed by the company. Changes to the overall balance between equity and debt have no effect on the cash flows, only on how they are effectively divided up between different types of investor. However, more advanced financial models subsequently demonstrated the limitations first recognized by Modigliani and Miller: factors of relevance include the impact of taxation and agency issues, i.e. conflicts of interests between executives, equity investors, and bondholders.
A basic understanding of a company’s capital structure, particularly its level of gearing, is a useful starting point when considering an investment in the company.
Investors in companies with capital structures based on equity would expect to receive returns on their investment via dividends. Capital growth is also likely when the company is performing well. However, one advantage of this structure from the company’s perspective is that payment of dividends is optional, giving the company the right to make no dividend payments during challenging trading periods.
A company with a capital structure based largely on debt is required to pay interest to the debt holders, regardless of how the company is performing. However, there may be tax advantages associated with debt repayments.
Careful thought needs to be given to capital-structure decisions, based on factors such as expected rate of investment return and cost of capital. Ill-judged capital-structure decisions can lead to serious financial problems.
Be clear about the differences between capital structure and financial structure—terms that are often confused. Capital structure is the equity/debt balance of a company’s long-term finances, whereas financial structure also includes short-term funding arrangements, as represented in the current liabilities on the company’s balance sheet.
Aim to understand the factors behind companies’ choice of capital structure. There are many considerations behind these decisions, including cash flow projections, possible taxation benefits, funding availability, industry factors, risk considerations, and cash management.
Dos and Don’ts
Consider the benefits of buying a combination of shares and debt when making an investment in a company. This approach would effectively lower the gearing of the investment opportunity relative to a shares-only purchase.
Bear in mind that, while differences between rival companies’ capital structures can seem significant, research based on extensions of the Modigliani–Miller theory has suggested that the benefits of adjustments to companies’ capital structures are frequently limited.
Don’t ignore a company simply because of its capital structure. An investor looking for a more highly geared proposition could buy shares in the company, then lend against them.
Don’t ignore the possible impact of agency problems when analyzing companies. Conflicts of interest can occur in many forms, even between stockholders, debt holders, and executives.