CAPITAL STRUCTURE DEFINITION, TYPES, IMPORTANCE, AND EXAMPLES

What Is Capital Structure?

Capital structure is the combination of debt and equity a company uses to finance its
overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash
flows and profits. Debt comes in the form of bond issues or loans, while equity may
come in the form of common stock, preferred stock, or retained earnings. Short-term
debt is also considered to be part of the capital structure.

KEY TAKEAWAYS

 Capital structure is how a company funds its overall operations and growth.

 Debt consists of borrowed money that is due back to the lender, commonly with
interest expense.
 Equity consists of ownership rights in the company, without the need to pay
back any investment.
 The debt-to-equity (D/E) ratio is useful in determining the riskiness of a
company's borrowing practices.
Dynamics of Debt and Equity
Both debt and equity can be found on the balance sheet. Company assets, also listed
on the balance sheet, are purchased with debt or equity. Capital structure can be a
mixture of a company's long-term debt, short-term debt, common stock, and preferred
stock. A company's proportion of short-term debt versus long-term debt is considered
when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-
to-equity (D/E) ratio, which provides insight into how risky a company's borrowing
practices are. Usually, a company that is heavily financed by debt has a more
aggressive capital structure and therefore poses a greater risk to investors. This risk,
however, may be the primary source of the firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets.
Companies benefit from debt because of its tax advantages; interest payments made
as a result of borrowing funds may be tax-deductible. Debt also allows a company or
business to retain ownership, unlike equity. Additionally, in times of low-interest rates,
debt is abundant and easy to access.

Equity allows outside investors to take partial ownership of the company. Equity is
more expensive than debt, especially when interest rates are low. However, unlike
debt, equity does not need to be paid back. This is a benefit to the company in the
case of declining earnings. On the other hand, equity represents a claim by the owner
on the company’s future earnings.

Why Do Different Companies Have Different Capital Structure?

Firms in different industries will use capital structures better suited to their type of
business. Capital-intensive industries like auto manufacturing may utilize more debt,
while labor-intensive or service-oriented firms like software companies may prioritize
equity.

How Do Managers Decide on Capital Structure?

Assuming that a company has access to capital (e.g. investors and lenders), they will
want to minimize their cost of capital. This can be done using a weighted average cost
of capital (WACC) calculation. To calculate WACC the manager or analyst will multiply
the cost of each capital component by its proportional weight.
How Do Analysts and Investors Use Capital Structure?

A company with too much debt can be seen as a credit risk. Too much equity,
however, could mean the company is underutilizing its growth opportunities or paying
too much for its cost of capital (as equity tends to be more costly than debt).
Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve
real-world optimal capital structure. What defines a healthy blend of debt and equity
varies depending on the industry the company operates in, and its stage of
development, and can vary over time due to external changes in interest rates and the
regulatory environment.

What Measures Do Analysts and Investors Use to Evaluate Capital Structure?

In addition to the weighted average cost of capital (WACC), several metrics can be
used to estimate the suitability of a company's capital structure. Leverage ratios are
one group of metrics that are used, such as the debt-to-equity (D/E) ratio or debt ratio.

The Bottom Line

Capital structure is the specific mix of debt and equity that a company uses to finance
its operations and growth. Debt consists of borrowed money that must be repaid, often
with interest, while equity represents ownership stakes in the company. The debt-to-
equity (D/E) ratio is a commonly used measure of a company's capital structure and
can provide insight into its level of risk. A company with a high proportion of debt in its
capital structure may be considered riskier for investors, but may also have greater
potential for growth.
DEBT CAPITAL

Debt capital is a fund that a company or organization raises by borrowing from lenders
or investors that must be paid with interest. Debt capital is a valuable source of funding
for businesses, and it can be used for various purposes, including expansion,
acquisition, and working capital.

Debt financing is usually provided in the form of loans, bonds, or other types of debt
securities. The investor determines the terms of the debt capital, such as the interest
rate, repayment period, and collateral requirements. However, companies that take on
too much debt can become over-leveraged and burdened if it fails to meet their debt
obligations.

Key Takeaways

 Debt capital definition refers to the money borrowed from lenders or investors by
a company or organization. Companies and organizations often use loans,
bonds, and other debt securities to raise capital.
 In addition, debt financing comes with a predetermined repayment structure. In
comparison, equity capital does not come with a repayment obligation.
 This form of financing aims to provide an organization with the funds to finance
its operation. Furthermore, it offers tax benefits and financial leverage.
  Investors and analysts use the debt-capital ratio to evaluate a company’s
financial risk and leverage.

DEBT CAPITAL EXPLAINED

Debt capital, also known as debt financing, is a form of financing that allows a company
to raise funds by borrowing money from creditors or investors. When utilizing this type
of financing, borrowers must repay the borrowed amount along with interest over a
specific period.

Furthermore, this form of funding can provide tax benefits for companies because the
interest paid on the debt is tax-deductible. Determining a company’s debt capital
structure is based on several factors, including financial objectives, borrowing capacity,
and willingness to take on debt.

Here’s an overview of the debt financing procedure:

 First, the company approaches potential investors, such as banks, or financial

institutions, to secure debt financing. Furthermore, the investor evaluates
creditworthiness, financial stability, and loan repayment ability.
 If the investor agrees to provide the debt capital, the company enters into a loan
agreement indenture outlining the loan terms.
 Therefore, the capital that a company receives through debt financing can be
utilized for various purposes, including expansion, acquisition, or working
capital.
 In addition, the company pays the common investor interest and repays the
principal amount of the loan when it matures.
 The terms of the agreement entitle the investor to receive interest and principal
payments.

Hence, by issuing debt securities, companies, and governments can access funds from
a broad range of investors, including institutional investors and pension funds.
Therefore, debt capital markets help investors with an opportunity to diversify their
investment portfolios and earn returns through fixed-income securities.

Investors use the debt-capital ratio to analyze a company’s financial risk and leverage.
Moreover, the debt-capital ratio is calculated by dividing a company’s total debt by its
total capital, including debt and equity. Overall, using this form of financing can provide
a company with greater flexibility and financial leverage.

TYPES

Generally, a company’s debt capital structure will comprise a mix of short-term and
long-term debt. The following are types of debt financing:

 Bank Loans: Borrowing bank loans from financial institutions or banks is

generally used for working capital or asset acquisition. 
 Bonds: These are debt securities sold to investors that pay either a fixed
or variable interest rate. 
 Lines Of Credit: These facilities allow a business to borrow money up to a
predetermined limit as needed.
 Equipment Financing: This type of debt financing wherein a company borrows
money to purchase equipment, which serves as collateral for the loan.
 Commercial Paper: This is a short-term unsecured promissory
note corporations’ issue to raise funds quickly.
 Small Business Administration (SBA) Loans: In the US, government provides
small business loans, typically with lower interest rates and more extended
repayment periods.
 Mezzanine Financing: This type of debt falls between secured debt and equity
in the capital structure. Moreover, these are typically unsecured and have
higher interest rates.

EXAMPLES

Let us understand the concept better with the help of an example.

Example #1

Let’s assume a small startup specializing in mobile app development. The company
wishes to expand its operations and develop new apps but requires additional funding.
So, the company decides to raise the needed capital through debt financing and issue
a bond to raise the necessary funds.

The bond has a $1 million face value and a 6% annual interest rate. Investors who hold
the bond will receive interest payments every six months, and the bond will mature in
ten years. The company raised $950,000 by selling the bond to investors, and the
funds will be utilized to finance its expansion plans.

By purchasing the bond, the bondholders have become the company’s creditors. As a
result, they are entitled to receive regular interest payments and the repayment of the
principal amount when the bond matures. The company must repay the bond in full
when it matures, but in the meantime, it will pay bondholders interest every six
months until maturity.

Example #2

Dream Unlimited Corporation is a Canadian real estate development firm. The firm

intends to provide ESG (Environmental, Social, and Governance) focused debt capital
to US markets. As a result, Aviro Real Estate Credit was established in collaboration
with PaulsCorp LLC. This new joint venture will give loans ranging from $25 million to
$150 million for acquiring, refinancing, and recapitalizing commercial real estate
assets.

Furthermore, Dream Unlimited Co. will restore the new entity’s stability and ESG lens.
Moreover, Paulscorp LLC. has a diverse background in development, asset
management, property management, construction management, and underwriting.

Vicky Shriff would oversee the new entity Aviro as its CEO. Aviro is authorized to offer
short-term, first-mortgage debt and various structured finance products for projects that
comply with ESG guidelines.

Michael Cooper, the President, and Chief Relationship Officer of Dream Unlimited Co.,
stated that the newly formed entity, Aviro, will have its headquarters in Denver,
Colorado, with additional offices in Toronto, Canada, New York, and Los Angeles,
California. Schiff and Kyle Geoghegan would be in charge of this.

ADVANTAGES AND DISADVANTAGES

Advantages 

1. Predictable cash flows: Interest and principal debt payments are usually fixed
and predictable, providing the borrower with a consistent cash flow stream. 
 2. Tax efficiency: Debt interest payments are tax deductible, which can reduce
the borrower’s overall cost of borrowing. 

3. Unlimited funding:  This financing can fund various activities, including

expansion, acquisitions, and research and development. 
4. Leverage: Debt financing allows businesses to leverage their existing assets,
potentially increasing return on equity.

Disadvantages

1. Risk of default: If a borrower cannot make interest or principal payments on its

debt, it may default on the loan, resulting in financial loss for the lender. 
2. Interest Payments:  Although interest payments are tax-deductible, they still
represent a high cost to the business. Therefore, the higher the interest rate, the
more expensive the debt financing becomes.
3. Debt service: Borrowers must devote a portion of their cash flow to debt
servicing, which can limit their ability to invest in growth or respond to
unexpected expenses. 
4. Negative impact on credit rating: A business with too much debt can
negatively impact its credit rating, making it harder to obtain future financing at a
favorable rate.

Debt Capital vs Equity Capital

Debt financing and equity capital are two types of financing those businesses can use
to fund their operations.

 Debt capital refers to funds borrowed by a company or organization that must be

repaid later, usually with interest. In contrast, Equity capital refers to funds
invested in a company in exchange for a stake. 
 Loans, bonds, and mortgages are all forms of debt capital. Stock
offerings, venture capital, and crowdfunding are all examples of equity
capital. 
 When a company raises debt financing, it is legally obligated to repay the
borrowed funds but does not relinquish ownership of the company. On the other
hand, when a company raises equity capital, it gives up a portion of its
possession in exchange for the funds. 
 Debt interest payments are tax deductible. However, equity dividend payments
are not.
FREQUENTLY ASKED QUESTIONS (FAQS)

How to calculate the cost of debt capital?

The cost of debt financing is the interest rate on a company’s outstanding debt. It is
calculated by dividing the annual interest expense (the amount the company owes in a
given year) by the total debt owed. For example, if a business has $100,000 in debt
and must pay $6,000 in interest each year, its cost of debt capital is 6%.

What are non-debt capital receipts?

Non-debt capital receipts are funds, a company or government receives from sources
other than borrowing or issuing debt. These funds can come from various sources,
including equity investments, government grants, and asset sales revenue.

What is good debt capital?

Good debt capital can help the company achieve its financial goals while maintaining a
healthy level of debt. Several factors contribute to suitable debt financing, including:

– Appropriate debt-to-equity ratio

– Low-interest rates

– Long-term debt

– Diversification

– Adequate cash flow

EQUITY CAPITAL

Equity Capital refers to the capital collected by a company from its owners and other
shareholders in exchange for a portion of ownership in the company. The company is
not liable to repay the fund raised through equity financing.
It is one of the primary sources through which businesses obtain capital to finance their
operations and overall development. The most common ways to raise equity funds are
through a public and private issue of shares, and accordingly, it is also classified into
private and public equity capital.
Key Takeaways
 Equity capital definition portrays it as the amount of money collected from owners
and other investors in exchange for a portion of ownership right in the company.
 It is exceptionally beneficial for companies since it raises large sums of money
that they can use for long-term projects.
 A good equity portfolio increases credit rating.
 The company does not need to repay the fund collected through equity financing.
However, they are also associated with disadvantages such as being expensive
for firms to raise and a complex dividend distribution process.
How to Calculate Equity Capital Cost?
The equity capital calculation method can vary based on the entity’s financial context.
However, the general practice is to look at the company’s balance sheet or statement
of profit and loss account to pick the value of total assets and total liabilities.

Total Equity = Total Assets – Total liabilities

The balance sheet portrays the value of total assets as the sum of total liabilities and
equities. Hence, total equity is the difference between total assets and liabilities.
Furthermore, the Capital Asset Pricing Model (CAPM) can calculate the equity capital
cost, indicating the rate of return that will flow to the shareholders. In other words, it is
the cost of distribution to shareholders. The calculation considers several factors,
including the status of the market and the company’s overall risk. It uses historical
information to come up with the pricing. The formula used to calculate the cost of
equity in this model is:
E(Ri) = Rf + βi * [E(Rm) – Rf]
In this formula, E(Ri) represents the anticipated return on investment, R f is the return
when risk is 0, βi is the financial Beta of the asset, and E(Rm) is the expected returns
on the investment based on market analyses.

EXAMPLE
In various instances, the company may require selling a portion of itself to gain equity
funds, and it creates a way for investors to own the company’s share. The equity
finance can be obtained through self-funding by owners, offering partnership to friends
and family, private investors, stock market issuance, venture capitalists, etc. In simple
terms, we can analyze that if the entity is a sole proprietorship, the equity section is
referred to as owner’s equity. In contrast, it is indicated as stockholders’ equity for a
corporation. 
The equity section of the balance sheet discloses quantitative values of components
like common stock, preferred stock, additional paid-in capital, retained
earnings, other comprehensive income (OCI), and treasury stock. For instance, look
into the balance sheet of Apple Inc., the shareholder’s equity section lists information
about shares authorized, issued, outstanding, additional paid-in capital, retained
earnings, and OCI. As of March 2021, Apple’s stockholder equity was $69.178 billion
and around 16.97 billion shares outstanding.

Advantages and Disadvantages

As with any investment, several advantages and disadvantages are associated with
equity fund.

The advantages are: 

  The stocks like common stocks and preferred stocks have no maturity date.
Consequently, the company does not have the right to demand back the equity
shares strictly. A shareholder would therefore be more secured when holding
equity shares.
 It increases the creditworthiness of a company. If it gains many equity
shareholders, then they act as a form of collateral for the company. It gives the
company more leverage to get more funds and negotiate better terms with
lenders or other stakeholders.
 It is not obligated always to pay dividends to equity shareholders for the
company. So, it will be helpful when the company faces a cash crunch. It can
then use the money intended for dividend distribution to pay for other events
without worrying about legal liabilities.
 For investors, equity shares are preferable in most cases since they command a
higher return on investment compared to other types of securities. However, it of
course, depends on the performance of the company.

It has several disadvantages as well, including: 

 The company’s ownership becomes more and more diluted as it gains more
equity shareholders. In some cases, this can make decision-making a slow
process since it involves many shareholders. It can make the company miss out
on opportunities that are tightly time-barred. 
 To a company, the cost of giving out equity shares is high. Equity shareholders
usually require a high return on investment, particularly in the long run.
 Managing equity capital, in this case, costs more for the company. For instance,
when paying out dividends, the money has to come out of profit after tax has
been paid. In the case of other types of financing, the company would pay in
interest, which would be tax-deductible, and therefore cost less for the company.
 Raising an equity fund is much more expensive than raising cash using other
methods for a company.
FREQUENTLY ASKED QUESTIONS (FAQS)

What are the three types of capital?

Capital is an essential component for managing business operations and growth. It is
generally classified into equity capital, debt capital, and working capital. The proper
proportion of debt and equity in the capital structure ensures the business’s financial
strength.
What is the equity capital market?
Equity Capital Markets (ECM) refers to a platform where companies, with the help of
other financial entities, raise capital through equity financing. ECM allows a wide array
of activities like marketing, distribution, and allocation of issues. Moreover, it mainly
includes primary equity issues like private placements and IPOs and secondary market
issues like stock exchanges, over-the-counter markets (OTC).
Is equity capital an asset?
No, equity is not an asset. The quantitative value of equity is derived by deducting
liabilities from assets. Equities are more like liabilities since they are attributable to the
investors, unlike assets owned by the business or company.

DEBT MARKET VS. EQUITY MARKET: WHAT'S THE DIFFERENCE?

Debt Market vs. Equity Market: An Overview

Debt market and equity market are broad terms for two categories of investment that
are bought and sold.
The debt market, or bond market, is the arena in which investment in loans are
bought and sold. There is no single physical exchange for bonds. Transactions are
mostly made between brokers or large institutions, or by individual investors.
The equity market, or the stock market, is the arena in which stocks are bought and
sold. The term encompasses all of the marketplaces such as the New York Stock
Exchange (NYSE), the Nasdaq, and the London Stock Exchange (LSE), and many
others.
KEY TAKEAWAYS

 In the equity market, investors and traders buy and sell shares of stock.
 Stocks are stakes in a company, purchased to profit from company dividends or
the resale of the stock.
 In the debt market, investors and traders buy and sell bonds.
 Debt instruments are essentially loans that yield payments of interest to their
owners.
 Equities are inherently riskier than debt and have a greater potential for big
gains or big losses.
 
IMPORTANT: The equity market is viewed as inherently risky while having the
potential to deliver a higher return than other investments.

Debt Market
Investments in debt securities typically involve less risk than equity investments and
offer a lower potential return on investment. Debt investments by nature fluctuate less
in price than stocks. Even if a company is liquidated, bondholders are the first to be
paid.

Bonds are the most common form of debt investment. These are issued by
corporations or by the government to raise capital for their operations and generally
carry a fixed interest rate. Most are unsecured but are issued with a rating by one of
several agencies such as Moody's to indicate the likely integrity of the issuer.

Risky Real Estate and Mortgage-Backed Debt

Real estate and mortgage debt investments are other large categories of debt
instruments. Here, the underlying asset securing the debt is real estate known as the
collateral. Many real estate- and mortgage-backed debt securities are complex in nature
and require the investor to be knowledgeable of their risks.

The Changing Value of Fixed-Rate Bonds

It is reasonable to ask why a fixed-rate investment can change in value. If an individual
investor buys a bond, it will pay a set amount of interest periodically until it matures, and
then can be redeemed at face value. However, that bond might be resold in the debt
market, called the secondary market.
The bond retains its face value at maturity. However, its real yield, or net profit, to a
buyer change constantly. It loses yield by the amount that has already been paid in
interest. The investment value increases or decreases with the constant fluctuations in
the going interest prices offered by newly-issued bonds. If the interest rate of return on
the bond is higher than the going rate, and the bond a reasonable time until maturity,
the value may be at par or above the face value.
Thus, in the secondary market, the bond will sell at a discount to its face value or a
premium to its face value.

Equity Market
Equity, or stock, represents a share of ownership of a company. The owner of an equity
stake may profit from dividends. Dividends are the percentage of company profits
returned to shareholders. The equity holder may also profit from the sale of the stock if
the market price should increase in the marketplace.
The owner of an equity stake can also lose money. In the case of bankruptcy, they may
lose the entire stake.
The equity market is volatile by nature. Shares of equity can experience substantial
price swings, sometimes having little to do with the stability and good name of the
corporation that issued them.
Volatility can be caused by social, political, governmental, or economic events. A large
financial industry exists to research, analyze, and predict the direction of individual
stocks, stock sectors, and the equity market in general.
The equity market is viewed as inherently risky while having the potential to deliver a
higher return than other investments. One of the best things an investor in either equity
or debt can do is to educate themselves and speak to a trusted financial advisor.