Ultimate Guide to Capital Structure

In this article, you’ll gain an in-depth insight into Capital Structure, including what it is, why it matters, and how it’s calculated. Let’s get into it.

What is Capital Structure?

Firstly, what is Capital Structure?

Capital Structure essentially represents the structure of a firm’s capital.

A firm’s capital broadly comprises of:

• Debt (this being what a firm has borrowed or raised by ‘debt financing’), and
• Equity (this being what a firm has raised by ‘equity financing’)

Capital Structure reflects the proportion of debt (or equity) financing a firm has relative to its total capital.

It’s one of the most important concepts in Corporate Finance and plays a pivotal role in applied investment banking

What is Debt Financing?

Debt financing refers to ‘financing’ raised by  debt.

Put simply, it refers to money that’s been raised by borrowing from lenders (i.e. debt holders).

These lenders might be banks, financial institutions, or debt investors.

What is Equity Financing?

Equity financing, as you may now have guessed, refers to ‘financing’ raised by equity.

In essence, this represents money that’s been raised from shareholders (aka ‘equity holders’, or equity investors).

The firm/company gives up a share of its business in exchange for money from investors.

Typically, public companies will raise equity financing from financial markets, with investment banks typically acting as intermediaries between the firm and investors.

Why Is Capital Structure Important?

A firm’s capital structure is important for three main reasons:

• the riskiness of the company
• the tax implications for the company
• its signalling of growth opportunities and future prospects

Let’s consider all three reasons individually.

Riskiness Of The Company

From a company’s standpoint, raising finance via debt is riskier compared to raising finance through equity.

That’s because debt finance results in a firm being legally obligated to make repayments to the lender.

As an example, if a company issues bonds to raise its debt finance, it is legally obligated to pay investors coupon payments and the par value at maturity (assuming it’s a straight / vanilla bond).

If you’re wondering what bonds are, we recommend reading our sister articles that explains how bonds work.

Now, coming back to the firm’s perspective on raising finance…

We’ve established that raising debt finance is risky for a firm because it’s legally obligated to make repayments.

Firms are not legally obliged to make any repayments to equity investors from whom they raise equity finance.

It’s important to note that they’re expected to pay dividends if they’re unable to find positive NPV projects. But they’re not legally required to do so.

Now, because the firm is legally obliged to make payments to debt investors (but not equity investors), this makes firms with debt riskier bets for equity investors.

The more debt a firm has, the more its legal repayments (including interest payments) will be. And therefore, the greater the risk is to equity investors because the firm faces a greater risk of insolvency or bankruptcy.

Thus, the greater the level of debt finance (relative to equity finance), the greater the risk of the company.

Note, importantly, that risk here is not referring to the risk of a stock measured by its standard deviation.

This form of risk is closer to the implication of gearing. Or more appropriately, it’s the risk that’s quantified by the Weighted Average Cost of Capital.

Let’s now consider the next factor that influences the importance of capital structure – tax.

Tax Implications For The Company

Capital Structure is important because it plays a direct role in the tax implications for a company.

The interest tax shield that is created as a result of interest payments on debt reduces the overall tax bill for companies.

Indeed, this is one of the reasons Apple Inc famously opted to borrow money despite having hundreds of billions of cash on its balance sheet.

For 2 firms that are identical in all aspects other than their capital structure, the one with debt will pay lesser tax compared to the one without any debt.

Seen from another perspective, the reduced tax bill for a firm with debt can also be interpreted as resulting to a lower Cost of Debt.

That’s because the effective rate of interest on its debt decreases as a result of lower tax being payable.

Crucially, this benefit does not always hold. Firms that take on too much debt may end up facing financial distress, which could result in significantly higher interest rates (i.e., cost of debt).

Does that make sense? If it doesn’t, we’d strongly recommend reading the articles on Interest Tax Shield and Cost of Debt linked above first, and then coming back to this article.

Signalling of Growth Opportunities and Future Prospects

Finally, Capital Structure is an important measure of signalling of a firm’s growth opportunities and future prospects.

Why is that so?

Let’s think about the point about the riskiness of the firm from earlier.

We established that a firm with debt is riskier compared to an identical firm with no debt.

But, what we didn’t highlight, was the potential cash outflows a firm will incur for each type of financing raised.

For debt finance, recall that the firm is legally obligated to make its repayments (including interest payments).

The total payments, however, are limited to the amount borrowed plus the interest payable.

In other words, there is a finite limit to the amount of debt repayments.

For equity financing on the other hand, there is no finite limit on equity payments.

Firms can be expected to pay their shareholders dividends forever (perpetually).

For a company with bright/good future prospects, the total payments to equity investors can be significantly greater vis-a-vis the total payments to debt investors (for the same amount of capital raised).

Thus, assuming a company has bright future prospects, it should almost always prefer debt financing vis-a-vis equity financing if it wants to minimise its future outflows to investors.

A firm that is not expecting a very bright future will probably do better by raising debt finance, because its payments will likely be lower compared to if it raised finance via equity.

This is because the Cost of Debt is lower than the Cost of Equity.

How to Calculate Capital Structure

Capital Structure is calculated as the proportion of debt (or equity) capital relative to total capital.

Mathematically, Capital Structure is calculated as…

   

Where:

• refers to the market value of a firm’s debt – its debt capital, and
• represents the market value of a firm’s equity (i.e. its Market Capitalization) – its equity capital

The debt value tends to focus on the long term debt of a company, meaning short term debts like overdrafts typically won’t feature in the calculation of Capital Structure.

Some people also write the formula for Capital Structure as the proportion of Debt and Equity, as…

   

We prefer the first version (i.e. debt to total capital) because this prevents confusion with the formula for Gearing (aka Financial Leverage).

Note, from a nomenclature standpoint, it’s somewhat common practice to use the term Debt Ratio to interchangeably mean the proportion of Debt to Equity, as well as the proportion of Debt to Total Capital (that being Debt + Equity).

And while one could write out the Capital Structure formula as the proportion of equity to total capital…

   

We still prefer the first version (i.e. debt as a proportion of total capital).

And on a similar note on nomenclature as above, it’s somewhat common practice to use the term Equity Ratio to interchangeably mean the proportion of Equity to Debt, as well as the proportion of Equity to Total Capital (that being Debt + Equity).

Now, importantly, because a firm’s total capital comprises of debt plus equity, the following will always be true:

   

And that is because the proportions of debt to total capital and equity to total capital will always equate to 1. Mathematically…

   

Is There An Optimal Capital Structure?

The short answer is yes. There is an optimal capital structure for each company.

The optimal capital structure is one that maximises firm value.

Put differently, it’s the one that minimises the firm’s cost of capital.

Optimal Capital Structure and Firm Value

Although they are two different statements, they’re essentially the same in that a firm’s value is maximised when its cost of capital is minimised (and vice versa).

That’s because, fundamentally, the value of a firm is calculated as…

   

Where:

• denotes the value of the firm
• represents the cash flow a firm is expected to generate at each time (be that Free Cash Flow or Free Cash Flow to Equity)
• reflects the firm’s appropriate discount rate (aka cost of capital)

For a company that has both debt capital and equity capital, its value would be calculated as…

   

Here:

• continues to denote the value of the firm
• represents the Free Cash Flow a firm is expected to generate at each time
• reflects the firm’s Weighted Average Cost of Capital (WACC)

A company that has no debt capital (i.e., it’s fully equity funded), its value would be calculated as…

   

Here:

• continues to denote the value of the firm
• represents the Free Cash Flow to Equity (aka “Flow to Equity”) a firm is expected to generate at each time
• reflects the firm’s Cost of Equity Capital

Note that, if the cost of capital is minimised, the fraction tends to infinity.

And this is precisely why the “maximisation of firm value” and “minimisation of cost of capital” are two sides of the same coin.

Visualising Capital Structure and Firm Value Maximisation Mathematically

If you don’t quite see it yet, take a look at this expanded form for the equation of the value of a firm:

   

Granted, the equation can look a tad bit scary, especially if math isn’t your friend.

But the only thing you need to takeaway at this stage is that the optimal capital structure is one that maximises firm value.

You should know by this stage that capital structure is calculated as:

   

And you can see this ‘Debt Ratio’ if you will, inside the equation for the value of a firm just above.

So it’s a case of finding the optimal value for that minimises the and as a result, maximises firm value.

Is the math really freaking you out? Chances are, you had quite a character of a math teacher in school. How about we get you past your fear of math once and for all? Take a look at our Financial Mathematics Primer course. It’s designed for absolute beginners, and by the end of the course, you’ll be writing your own mathematical proof.

What About Capital Structure Theory?

Most theories in Finance tend to be named to reflect precisely what they’re about. For instance, the theory of portfolio optimization tends to focus on exactly that – portfolio optimization.

The theory of Capital Structure on the other hand, is less focused on “Capital Structure” itself, and more about the implications of capital structure on firm value.

Essentially, the Capital Structure Theory revolves around the firm value maximization problem.

In other words, it focuses on finding the optimal capital structure that maximizes firm value.

The most notable scholars are those who effectively defined this problem formally – they being Franco Modigliani and Merton Miller.

A deep dive into the Capital Structure Theory is beyond the scope of this particular article, as are the propositions of Modigliani and Miller.

But if you would like to see an article with deep dives into these concepts, reach out to us and let us know.

Wrapping Up

In summary, you learned that Capital Structure essentially represents the structure of a firm’s capital.

You also learnt that a firm’s capital structure is important for three main reasons, including:

• the riskiness of the company
• the tax implications for the company
• its signalling of growth opportunities and future prospects

You’ve explored the concepts of Optimal Capital Structure and, briefly, Capital Structure Theory.

Lastly, you’ve learned that capital structure is calculated as…

   

And that there are alternative versions for the capital structure formula, but this is likely your best bet.

Alright, hopefully, all of this makes sense. If any part of the article isn’t quite clear, please do give it another read.

If you want to master other concepts in Finance in an engaging and comprehensive way, take a look at our finance and investing courses.