Capital Structure

Capital structure is the permanent financing of the business through the use debt and stock. Capital, in the most basic terms, is money. All businesses must have capital in order to purchase assets and maintain their operations. Business capital comes in two main forms: debt and equity. Debt refers to loans and other types of credit that must be repaid in the future, usually with interest. In contrast, equity generally does not involve a direct obligation to repay the funds. Instead, equity investors receive an ownership position which usually takes the form of stock in the company.

The overall objective of a business is to find an "optimal" capital structure - the right mix of capital sources (debt and equity) that minimizes the overall cost of capital and maximizes values to the shareholders (owners of the business). When a company needs to raise capital, they have two choices - issue debt or issue stock. Debt is represented by bonds which are long-term instruments sold to investors. Stock is the ownership interest of the business and depending upon the rules of incorporation, stockholders will have certain rights. There are advantages and disadvantages of the two sources of capital:

Some advantages to using stock are:

No fixed payments are required to investors; dividends are paid only as earnings are available.

No maturity date on the security, the invested capital does not have to be repaid.

Improves the credit worthiness of the company.

Some disadvantages to using stock are:

Dilutes the earnings per share to shareholders.

Issuance costs are higher than debt.

Issuing more stock can increase the overall cost of capital.

Dividend payments to shareholders are not tax deductible.

Some advantages to using debt are:

Interest payments are tax deductible.

Does not dilute earnings per share or control within the company.

Cost is fixed; interest and principal do not change.