2. Capital Structure Basics

The mix of the various sources of capital define the capital structure of the firm. The two main sources of capital are common equity and debt. The key characteristics of these sources of capital are as follows:

 

Common equity

  • Common equity is usually split into a number of shares of common stock
  • Common stock is a security that represents ownership in a corporation.
  • Holders of common stock have a control right. They exercise control by electing a board of directors and voting at the shareholder meeting on corporate policy. 
  • Common stockholders have a residual claim on income. They are at the bottom of the priority ladder when it comes to cash distributions. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other claimholders have been paid in full.

 

Debt

  • Debt, in contrast, represents a contractual claim on regular interest payments and repayment of notional.
  • If a firm fails to meet the legal obligations (or conditions) of a debt contract, it is in default.
  • Debt comes in many different forms. For example:
    • Different maturities: Short-term vs. long-term debt
    • Different interest rates: Fixed vs. floating interest rates
    • With or without collateral: Secured vs. unsecured 
    • Different seniorities: Senior, subordinated, junior
    • Different counterparties: e.g., exchange traded bonds vs. bank loans

  

In addition to debt and equity, there are financing instruments that are generally referred to as mezzanine financing. These instruments usually have characteristics that are a mixture between debt and equity. A convertible bond, for example, represents a debt claim (bond) that can be converted into common stock. Similarly, preferred stock is an equity security that has characteristics that resemble (but do not represent) a debt claim. To better understand these mezzanine financing instruments, it is therefore important to learn more about their two main ingredients, debt and equity. The section "Understanding and Valuing Debt and Equity" will present the conceptual framework for that analysis.

 

The summary lists above show that debt and equity have strikingly different characteristics---a fact that cannot be stressed enough. Most importantly, the two instruments differ with respect to their property rights and their cash flow rights. Whereas equity represents ownership in a company, debt does not. In contrast, the company has a legal obligation to make the contractual debt payments whereas shareholders generally have no claims under law for dividend payments. As we will see in much more detail later on, these differences can have far reaching implications for many important dimensions of the company:

  • The firm's tax bill: Because interest expenses are tax deductible and dividend payments are not, debt financing has a tax advantage over equity financing.
  • Risk of financial distress: Debt financing, however, also increases the likelihood of financial distress, that is, the probability that the firm will not be able to fulfil all its financial obligations.
  • Willingness to take business risks: Debtholders receive their maximum payoff if the firm does not default on its obligations. Therefore, it is in the best interest of the debtholders to pursue a business strategy that minimizes default risk. Shareholders, in contrast, might be more open to risky business decisions, as they fully benefit from the upside of these endeavours.
  • Incentives to work hard: Financing decisions often also have far-reaching incentive implications. For example, debt financing could induce managers to work harder and be more diligent with the firm's resources so that the firm can fulfil its contractual obligations vis-a-vis the debtholders.
  • Performance metrics: The way a company is financed can significantly influence popular performance metrics such as earnings per share (EPS) and return on equity (ROE). When using such metrics to assess the performance of a firm (or to set management bonuses), it is therefore important to understand how they are affected by leverage.

 

These considerations suggest that both debt and equity have their respective advantages and disadvantages. The key for the financial manager will be to find the proper balance to solve these trade-offs. The session on the debt-equity choice will look at this issue in detail.

 

To assess the capital structure of the company and understand whether the aforementioned trade-offs are balanced sufficiently, financial analysts compute a series of ratios and metrics. These analyses are the topic of the next section.