Capital Structure

Capital Structure ⇒ refers to the way a firm chooses to finance its business. Should the company obtain financing by borrowing (by issuing bonds or borrowing from a bank) or by issuing equity (shares)? Or if both, in what proportion?

Equity represents ownership, and it does not need to be repaid. Debt must be repaid, either as interest and principal payments paid together or interest only during the term of the borrowing with all the principal due at the debt’s maturity date.

The choice a company makes between debt and equity will influence the company’s flexibility and thus its ability to make certain decisions in the future. If the company chooses to use debt, it will need to service the debt in the future by making regular interest or interest and principal payments. On the other hand, additional debt does not cause the owners of the company to lose any voting control or dilute their ownership. In contrast, if additional equity is used, the company will not be obligated to make interest payments, but the ownership interest of the present owners will be diluted and they will lose some voting control.

Though there is no one correct answer to this question of debt versus equity, the goal of the company will be to obtain the lowest-cost financing possible.

Another consideration in attempting to obtain low-cost financing is the fact that the more financing (either debt or equity) a company has, the more expensive each additional amount of financing will be.