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http://en.wikipedia.org/wiki/Capital_structure
You often hear corporate officers, professional investors, and analysts discuss a
company's capital structure. You may not know what a capital structure is or why you
should even concern yourself with it, but the concept is extremely important because it
can influence not only the return a company earns for its shareholders, but whether or
not a firm survives in a recession or depression. Sit back, relax, and prepare to learn
everything you ever wanted to know about your investments and the capital structure of
the companies in your portfolio!
Equity Capital: This refers to money put up and owned by the shareholders
(owners). Typically, equity capital consists of two types: 1.) contributed capital,
which is the money that was originally invested in the business in exchange for
shares of stock or ownership and 2.) retained earnings, which represents
profits from past years that have been kept by the company and used to
strengthen the balance sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company can
utilize because its "cost" is the return the firm must earn to attract investment. A
speculative mining company that is looking for silver in a remote region of Africa may
require a much higher return on equity to get investors to purchase the stock than a
firm such as Procter & Gamble, which sells everything from toothpaste and shampoo
to detergent and beauty products.
considered long-term bonds because the company has years, if not decades,
to come up with the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper utilized by giants
such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour
loans from the capital markets to meet day-to-day working capital requirements such
aspayroll and utility bills. The cost of debt capital in the capital structure depends on
the health of the company's balance sheet - a triple AAA rated firm is going to be able
to borrow at extremely low rates versus a speculative company with tons of debt,
which may have to pay 15% or more in exchange for debt capital.
Other Forms of Capital: There are actually other forms of capital, such
as vendor financing where a company can sell goods before they have to
pay the bill to the vendor, that can drastically increase return on equity but
don't cost the company anything. This was one of the secrets toSam
Walton's success at Wal-Mart. He was often able to sell Tide detergent
before having to pay the bill to Procter & Gamble, in effect, using PG's
money to grow his retailer. In the case of an insurance company, the
policyholder "float" represents money that doesn't belong to the firm but that
it gets to use and earn an investment on until it has to pay it out for accidents
or medical bills, in the case of an auto insurer. The cost of other forms of
capital in the capital structure varies greatly on a case-by-case basis and
often comes down to the talent and discipline of managers.
have, the debt will be much lower risk than if you operate a theme park in a tourist
town at the height of a boom market. Again, this is where managerial talent,
experience, and wisdom comes into play. The great managers have a knack for
consistently lowering theirweighted average cost of capital by increasing productivity,
seeking out higher return products, and more.
To truly understand the idea of capital structure, you need to take a few moments to
readReturn on Equity: The DuPont Model to understand how the capital structure
represents one of the three components in determining the rate of return a company
will earn on the money its owners have invested in it. Whether you own a doughnut
shop or are considering investing in publicly traded stocks, it's knowledge you simply
must have.
http://beginnersinvest.about.com/od/financialratio/a/capital-structure.htm
Capital Structure Overview
Capital structure refers to the way a corporation finances its assets through some combination of equity,
debt, or hybrid securities. A firm's capital structure is the composition or 'structure' of its liabilities. For
example, a firm that sells 20 billion dollars in equity and 80 billion dollars in debt is said to be 20% equityfinanced and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred
to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources.
Gearing Ratio is the proportion of the capital employed by the firm which comes from outside of the
business, such as by taking a short term loan.
Capital Structure.
Capital Structure shows how a company's assets are built out of debt and equity.
Modigliani and Miller created a theory of Capital Structure in a perfect market. There are several
qualifications for a "perfect market":
Trade-off theory allows bankruptcy cost to exist. It states that there is an advantage to financing with debt
(the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and
the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on
this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may
explain differences in Debt/Equity ratios between industries, but it doesn't explain differences within the
same industry.
Pecking Order Theory tries to capture the costs of asymmetric information. It states that companies
prioritize their sources of financing (from internal financing to issuing shares of equity) according to least
resistance, preferring to raise equity for financing as a last resort. Internal financing is used first. When
that is depleted, debt is issued. When it is no longer sensible to issue any more debt, equity is issued.
This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal
financing when available, while debt is preferred over equity if external financing is required. Thus, the
form of debt a firm chooses can act as a signal of its need for external finance.
The Pecking Order Theory is popularized by Myers (1984), when he argues that equity is a less preferred
means to raise capital because when managers (who are assumed to know better about true condition of
the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued
and managers are taking advantage of this over-valuation. As a result, investors will place a lower value
to the new equity issuance.