A business invests in new plant and equipment to generate additional revenues and income—the basis for its growth. One way to pay for investments is to generate capital from the company’s operations. Earnings generated by the company belong to the owners and can either be paid to them—in the form of cash dividends—or plowed back into the company. The owners’ investment in the company is referred to as owners’ equity or, simply, equity. If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the value of the company and, hence, enhance the value of their equity. But earnings may not be sufficient to support all profitable investment opportunities. In that case the CFO is faced with a decision: recommend that the CEO and the board forgo profitable investment opportunities or raise additional capital. A CFO can raise new capital either by borrowing or by selling additional ownership interests or both. In this post we discuss the decision about how the company should be financed: the mixture of debt and equity. This decision is referred to as the “capital structure decision“.
Debt Versus Equity
The capital structure of a company is some mix of debt, internally generated equity, and new equity. But what is the right mixture? The best capital structure depends on several factors. If a company finances its activities with Debt, the creditors expect the amount of the interest and principal—fixed, Legal commitments—to be paid back as promised. Failure to pay may result in legal actions by the creditors.
Suppose a company borrows $100 million and promises to repay the $100 million plus $5 million in one year. Consider what may happen when the $100 is invested:
- If the $100 million is invested in a project that produces $120, the company pays the lender the $105 million the company owes and keeps the $15 million profit.
- If the project produces $105 million, the company pays the lender $105 Million and keeps nothing.
- If the project produces $100 million, the company pays the lender $105 Million, with $5 million coming out of company funds.
So if the company reinvests the funds and gets a return more than the $5 Million (the cost of the funds), the company keeps all the profits. But if the project returns $5 million or less, the lender still gets her or his $5 million. This is the basic idea behind financial leverage—the use of financing that has fixed, but limited payments.
If the company has abundant earnings, the owners reap all that remains of the earnings after the creditors have been paid. If earnings are low, the creditors still must be paid what they are due, leaving the owners nothing out of the earnings. Failure to pay interest or principal as promised may result in what becalled “financial distress“.
Financial distress is the condition where a company makes decisions under pressure to satisfy its legal obligations to its creditors. These decisions may not be in the best interests of the owners of the company.
With equity financing there is no obligation. Though the company may choose to distribute funds to the owners in the form of cash dividends, there is no legal requirement to do so. Furthermore, interest paid on debt is deductible for tax purposes, whereas dividend payments are not tax deductible.
One measure of the extent debt is used to finance a company is the debt ratio, the ratio of debt to equity:
Debt ratio = Debt/Equity
This is a relative measure of debt to equity. The greater the debt ratio, the greater the use of debt for financing operations relative to equity financing.
Another measure is the debt-to-assets ratio, which is the extent to which the assets of the company are financed with debt:
Debt-to-assets Ratio = Debt / Total assets
This is the proportion of debt in a company’s capital structure, measured using the book or carrying value of the debt and assets. It is often useful to focus on the long-term capital of a company when evaluating the capital structure of a company, looking at the interest-bearing debt of the company in comparison with the company’s equity or with its capital.
The capital of a company is the sum of its interest-bearing debt and its equity.
The debt ratio can be restated as the ratio of the interest-bearing debt of the company to the equity:
Debt-equity Ratio = Interest-bearing debt / Equity
And the debt-to-assets can be restated as the proportion of interest-bearing debt of the company’s capital:
Debt-to-capital Ratio = Interest-bearing Debt / Total capital
By focusing on the long-term capital, the working capital decisions of a company that affect current liabilities, such as accounts payable are removed from this analysis. The equity component of all of these ratios is often stated in book or carrying value terms. However, when taking a markets perspective of the company’s capital structure, it is often useful to compare debt capital with the market value of equity. In this latter formulation, for example, the total capital of the company is the sum of the interest-bearing debt and the market value of equity.
If market values of debt and equity are the most useful for decision making, should the the business ignore book values? The answer is “No“, why? Because book values are relevant in decision making also. For example: bond covenants are often specified in terms of book values or ratios of book values. As another example: dividends are distinguished from the return of capital based on the availability of the book value of retained earnings. Therefore, though the focus is primarily on the market values of capital, the CFOs must keep an eye on the book value of debt and equity as well.
There is a tendency for companies in some sectors and industries to use more debt than others. We can make some generalizations about differences in capital structures across sectors:
- Companies that are more reliant upon research and development for new products and technology—for example, pharmaceutical companies—Tend to have lower debt-to-asset ratios than companies without Such research and development needs.
- Companies that require a relatively heavy investment in fixed assets tend to have lower debt-to-asset ratios. It is also interesting to see how debt ratios compare within sectors and within industries in a sector. For example, within the utilities sector, the Electric utility industry has a lower use of debt than both the water and gas industries. Yet within each industry there is variation of debt ratios. For example, within the beverage industry, Cotton Corporation, maker of retail brand soft drinks, has a much higher portion of debt in its capital structure than, say, the Coca-Cola Company.
By focusing on the long-term capital, the working capital decisions of a company that affect current liabilities, such as accounts payable are removed from this analysis. The equity component of all of these ratios is often stated in book or carrying value terms. However, when taking a markets perspective of the company’s capital structure.
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