When we hear those terms, we always wonder what could be behind it!! I know I did, and so did a few other people in my class. It sounds complicated, and reading the academic definitions for it doesn’t make it simpler!
However, it is less complicated than it looks like. Remember in the first posts, we talked about WACC (weighted average cost of capital). We saw that companies have two major different ways of finance. There is:
- Equity: high risks, high returns demanded
- Debt: lower risks, lower returns expected
Each of these ways of finance has a different
weight in the capital structure of a company, and therefore a specific impact.
Indeed, the capital structure of the company is the way a company uses to model
its capital and it is impacted by every financial choice the company will make.
Both have their own pros and cons. For example,
if there are a few bad economic years, if the capital structure of a company is
mainly made of debt, then there can be a problem when the company will have to
repay the interest of the debt (or cost of debt): the interests of the debt
have to be repaid no matter what. On the other side, in the same circumstances,
if the company’s capital structure is mainly made with equity, it can always
decide not to repay anything just yet. In this case, it seems like equity is a
much better way of finance than debt. But it is not always the case! I think
that risks that exist when a company uses equity to finance its operation are
high, and sometimes too high to be taken.
Beside, another point is important in the
choice of capital structure: how about shareholder value? I’ll let you do the
math in details, but when a company chose equity, it has to issue new share.
And by issuing these new shares, most of the time, it decreases the share
price, and thus shareholder value. Whereas, if, in the same circumstances, the
company uses debt and borrow money, the share price could have gone up. Of
course, these statements are based on the hypothesis that the firm rate of
return is higher than the rate of interest set by the bank.
It is now, I think, much easier to see where
the strategic advantage will come from. Indeed, the capital structure of a
company is a key element in its success or failure. The company’s capital
structure is what will make sure it keeps going during all economic times (good
or bad). The way of structuring the capital could give a company major gain,
over its competitor, in a long term period. This is the definition of a
competitive advantage.
To conclude, I think that the capital structure
of a company is one of the most important thing to use in the decision making
process. For me, debt is one of the safest ways for a company to finance its
operation and therefore, it should be given priority over equity, which is in
my opinion too risky. But, this is just my opinion, what do you think?
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