Which one of the following questions involves a capital structure decision?

Introduction

Capital structure refers to the specific mix of debt and equity used to finance a company’s assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility. Financial flexibility allows a company to raise capital on reasonable terms when capital is needed. Conversely, debt represents a cheaper, finite-to-maturity capital source that legally obligates a company to make promised cash outflows on a fixed schedule with the need to refinance at some future date at an unknown cost.

As we will show, debt is an important component in the “optimal” capital structure. The trade-off theory of capital structure tells us that managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost of capital, which in turn maximizes company value. That optimal capital structure represents a trade-off between the cost-effectiveness of borrowing relative to the higher cost of equity and the costs of financial distress.

In reality, many practical considerations affect capital structure and the use of leverage by companies, leading to wide variation in capital structures even among otherwise-similar companies. Practical considerations affecting capital structure include the following:

• business characteristics: features associated with a company’s business model, operations, or maturity; 
• capital structure policies and leverage targets: guidelines set by management and the board that seek to establish sensible borrowing limits for the company based on the company’s risk appetite and ability to support debt; and 
• market conditions: current share price levels and market interest rates for a company’s debt. The prevalence of low interest rates increases the debt-carrying capacity of businesses and the use of debt by companies. 

Because we are considering how a company minimizes its overall cost of capital, the focus is on the market values of debt and equity. Therefore, capital structure is also affected by changes in the market value of a company’s securities over time.

We tend to think of capital structure as the result of a conscious decision by management, but it is not that simple. For example, unmanageable debt, or financial distress, can arise because a company’s capital structure policy was too aggressive, but it also can occur because operating results or prospects deteriorate unexpectedly.

Finally, in seeking to maximize shareholder value, company management may make capital structure decisions that are not in the interests of other stakeholders, such as debtholders, suppliers, customers, or employees.

If you are a stock investor who likes companies with good fundamentals, then a strong balance sheet is important to consider when seeking investment opportunities.

By using three broad types of measurements—working capital, asset performance, and capital structure—you may evaluate the strength of a company's balance sheet, and thus, its investment quality.

A firm's judicious use of debt and equity is a key indicator of a strong balance sheet. A healthy capital structure that reflects a low level of debt and a large amount of equity is a positive sign of investment quality.

This article focuses on analyzing a company's capital structure portion of the balance sheet.

Key Takeaways

• Capital structure refers to a company's mix of capital—its debt and equity.
• Equity is a company's common and preferred stock plus retained earnings.
• Debt typically includes short-term borrowing, long-term debt, and a portion of the principal amount of operating leases and redeemable preferred stock.
• Important ratios used to analyze capital structure include the debt ratio, the debt-to-equity ratio, and the long-term debt to capitalization ratio.
• Credit agency ratings help investors assess the quality of a company's capital structure.

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Optimal Capital Structure

Capital Structure Terminology

Capital structure

Capital structure describes the mix of a firm's long-term capital, which is a combination of debt and equity. Capital structure is a type of funding that supports a company's growth and related assets. Sometimes it's referred to as capitalization structure or simply capitalization.

Expressed as a formula, capital structure equals debt obligations plus total shareholders' equity:

Capital Structure = DO + TSE

where:

DO = debt obligations
TSE = total shareholders’ equity

Equity

The equity portion of the debt-equity relationship is simple to define. In a capital structure, equity consists of a company's common and preferred stock plus retained earnings. This is considered invested capital and it appears in the shareholders' equity section of the balance sheet. Invested capital plus debt comprise the capital structure.

Debt

Debt is less straightforward. Investment literature often equates a company's debt with its liabilities. However, there is an important distinction between operational liabilities and debt liabilities.

Operational liabilities are what a company has to pay to keep the business running, such as salaries. Debt liabilities form the debt component of capital structure although investment research analysts do not agree on what constitutes a debt liability.

Many analysts define the debt component of capital structure as a balance sheet's long-term debt. However, this definition is too simplistic. The debt portion of a capital structure should consist of short-term borrowings (notes payable), long-term debt, and two-thirds (a rule of thumb) of the principal amount of operating leases and redeemable preferred stock.

When analyzing a company's balance sheet, seasoned investors would be wise to use this comprehensive total debt figure.

Ratios Applied to Capital Structure

In general, analysts use three ratios to assess the strength of a company's capitalization structure. The first two are popular metrics:

• The debt ratio (total debt to total assets)

• The debt-to-equity (D/E) ratio (total debt to total shareholders' equity)

A third ratio is one of the capitalization ratios. Referred to as the long-term debt to capitalization ratio, it's calculated as long-term debt divided by (long-term debt plus shareholders' equity). It delivers key insights into a company's capital position.

The debt ratio relates to how much of a company's assets are paid for with debt. The greater the ratio, the more leveraged a company may be. The problem with this measurement is that it is too broad in scope and gives equal weight to operational liabilities and debt liabilities.

The same criticism applies to the debt-to-equity ratio. Current and operational liabilities, especially the latter, represent ongoing obligations. Also, unlike with long-term debt, there are no fixed payments of principal or interest attached to operational liabilities.

On the other hand, the capitalization ratio that compares the long-term debt component to the debt and equity in a company's capital structure can present a clearer picture of financial health. Long-term debt can cost less than shareholder equity because it can be tax-deductible.

Expressed as a percentage, a low number indicates less debt which usually is more desirable than a large amount of debt.

Optimal Relationship Between Debt and Equity

Unfortunately, there is no magic ratio of debt to equity to use as guidance. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development.

Nonetheless, since investors are better off putting their money into companies with strong balance sheets, the optimal measurement of debt to equity generally should reflect lower levels of debt and higher levels of equity.

Not only is too much debt a cause for concern, too little debt can be as well. This can signify that a company is relying too much on its equity and not making efficient use of its assets.

About Leverage

In finance, leverage (debt) is a perfect example of the proverbial two-edged sword. Astute use of leverage can increase the financial resources available to a company for growth and expansion. Leverage that's mishandled can mean trouble for a company.

With leverage, the assumption is that management can earn more using borrowed funds than what it would pay in interest expense and fees on them. However, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its various borrowing commitments.

The Problem With Too Much Leverage

A company that is too highly leveraged (too much debt relative to equity) might find that creditors will refuse to lend it any more and may even take ownership of its assets. Or, it could experience diminished profitability as a result of paying steep interest costs. In addition, a firm could have trouble meeting its operating and debt liabilities during periods of adverse economic conditions.

If the overleveraged company's particular business sector is extremely competitive, competing companies could take advantage of its position by swooping in to grab more market share. A worst-case scenario might be a firm needing to declare bankruptcy.

Credit Rating Agencies

Credit rating agencies examine the creditworthiness of companies. Their ratings of the debt issued by companies can help investors determine whether that debt is risky as an investment.

The primary credit rating agencies are Moody's, Standard & Poor's (S&P), and Fitch. These entities conduct formal risk evaluations of a company's ability to repay principal and interest on debt obligations, primarily on bonds and commercial paper. The Securities and Exchange Commission conducts an oversight study of credit rating agencies annually on behalf of investors.

So, as an investor, you should be happy to see high ratings on the debt of companies in which you may invest. Likewise, you should be wary of a company with poor ratings.

Credit rating agencies use ratings that typically distinguish between investment grade and non-investment grade debt.

What Is Capital Structure?

Capital structure represents debt plus shareholder equity on a company's balance sheet. Understanding it can help investors size up the strength of the balance sheet and the company's financial health. That, in turn, can aid investors in their investment decision-making.

What Is a Credit Rating Agency?

A credit rating agency is a company that offers ratings for debt issued by companies. An agency, such as Moody's or Standard & Poor's, rates the debt according to a company's ability to pay principal and interest to the debt holders. Each agency has its rating method. Generally, the higher the rating, the better the risk for investors that the company will pay back what it borrowed.

What's the Difference Between the D/E Ratio and a Capitalization Ratio?

The D/E ratio compares a company's debt position to its equity position. The calculation for this ratio is total debt divided by total equity. The long-term debt to capitalization ratio (one of several capitalization ratios) compares long-term debt to the capital structure of a company, which is represented by long-term debt and total shareholder equity. The calculation for the long-term capitalization ratio is long-term debt divided by the total of long-term debt and shareholder equity.

The Bottom Line

A company's capital structure constitutes the mix of equity and debt on its balance sheet. Though there is no specific level of each that determines what a healthy company is, lower debt levels and higher equity levels are preferred.

Various financial ratios are used to analyze the capital structure of a firm. These can give investors and analysts a view of how a company compares with its peers and therefore its financial standing in its industry.

The ratings provided by reputable credit agencies also help shed light on the capital structure of a firm.

Which of the following is capital structure decision?

Which one of the following questions involved a capital budgeting decision?

What is an example of a capital structure decision?

What are the 4 types of capital structure?