Chapter 14. Distributions to Shareholders: Dividends and Repurchases

Chapter 15. Capital Structure Decisions

Finance – Week 7 Lecture

Capital Structure

Capital structure can sound like a large, scary subject to students who may be new to finance. It’s a crucial area to understand and really isn’t all that scary once you understand what the two key components are: debt and equity. That’s it! Capital structure refers to how an organization is financed. In an earlier lecture I referred to our balance sheet and the accounting equation: assets = liabilities + stockholder’s equity. I said that I like to think of it as what we have (assets) and where we got it from (borrowed money or others invested their money). Capital structure simply refers to the “how we got it” side of my equation. By assessing the capital structure of an organization we can see how heavily the organization relies on debt or equity to finance their organization. So while the term capital structure may sound like a big, complex concept, it’s really just a matter of seeing how much debt an organization has in comparison to the amount of equity they have.

Debt can be short or long term and comes in various shapes and sizes. We can owe money to our trade partners which is commonly known as accounts payable. We may have notes payable to other companies or banks. They can be short or long term depending on the terms of the note. We may also have revolving lines of credit or other types of loans. None of these are generally free, so assessing how much debt we have can help us determine how much it’s costing the organization in interest. Debt is also a structured item which means we have specific terms for the interest that is paid and the due dates for incremental payments or payments in full at the end of a note. Debt presents more risk than equity since we are obligated to repay the debt and it requires us to pay interest. Debt, however, does not require the organization to give up ownership. It also offers a bit of a tax break in the form of interest expense. While paying interest does indeed cost money, interest expense is tax deductible, and thus lowers taxable income and income tax expense.

Equity, on the other hand, involves investors contributing money into the organization in exchange for partial ownership. Thus, it is not required that equity be paid back. It presents less risk since there are no payments nor is there any interest. This also means, however, that there are no tax breaks when equity is used. Dividends are not tax deductible. They are, however, optional. If the organization is not profitable or does not have the cash available, issuing a dividend is not required. The organization has, however, given up partial ownership in exchange for the investment. There are two common types of stock issued to investors: common and preferred. Common stock often has a lower par value and is not guaranteed a dividend. They do have the right to vote at board meetings. Preferred stockholders, on the other hand, generally do not have the right to vote, but are sometimes guaranteed a divided. Preferred stockholders also stand in line in front of the common stockholders should the organization fold and liquidate.

Both debt and equity have advantages and disadvantages. There is no magical “ideal” capital structure that will work for every organization. Each organization is different and must assess its needs, resources, and tolerance for risk before deciding on the balance of debt and equity that will be most effective. Some firms have a more stable cash flow and are able to assume more debt and risk without problem. Other firms, however, may not have the reliable cash flow and may shy away from debt and the risk it poses. The economy and industry in which the organization operates will also play a role in how readily available loans and investors are. New start-up businesses sometimes find it difficult to obtain investors and may rely more on debt to get the organization started. Other new firms may have lots of interest from investors but the owner isn’t willing to give up ownership. Some types of businesses have a history of high failure rates and struggle to find a band willing to take a risk and issue a loan. The attributes of the owner, organization, business, industry, location, and much more all come into play when approaching whether or not to use debt, equity, or both to fund the start-up and growth of an organization.

Whatever the elements are, the key is that management carefully consider all the advantages and disadvantages of debt and equity before choosing the structure that will best suit their needs. Each firm is unique and finding the right balance between debt, equity, or both, takes time and research. What works really well for one organization may very well drive another organization right out of business.

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