Capital Structure: The Debt vs Equity Argument
A major topic of debate within Corporate Finance, the capital structure of a company refers to how they are able to finance anything that they do. Whether it be through debt or equity, the argument surrounds the pursuit for an ‘optimum’ capital structure, which would enable a company to fulfil financial goals whilst not taking on a huge amount of risk. This article will look at capital structure explaining its importance, current market trends and why it is so difficult to find this ‘optimum’ solution.
What Is Capital Structure?
The capital structure of a company is all about how they finance their operations and growth opportunities. Made up of a combination of debt and equity, a company’s capital structure is integral to its success because it is what enables the firm to strive towards their economic goals, and pay their bills.
Debt has been used by companies for hundreds of years to finance a whole array of various avenues. A company’s debt is borrowed money being used in the business that at some point needs to be paid back. This debt generally comes in the form of loans or bonds, with most major companies using both forms. Though they are similar, there are some distinct differences between the two. With a loan, the company receives money from a creditor (usually a financial institution or an entity with sufficient spare capital) and agrees to pay interest on the loan on top of regular repayments back to the creditor. Bonds on the other hand are debt instruments sold by the company themselves to raise capital. Governments and investors purchase these bonds in return for a steady stream of payments over the bond’s ‘lifetime’ before receiving back their original payment at the end. The major difference however is that loans are usually non-tradeable meanwhile bonds can be traded on a market meaning their value can rise and fall.
Equity refers to financing through the sale of stocks and shares. In choosing equity via issuing shares as method of finance, companies will have their shares listed on a stock exchange to be traded. Equity also covers retained earnings, which are previous amounts of money taken from profits which have been kept to finance future operations.
Why Is the Capital Structure of a Company Important?
As previously mentioned, capital structure is one of the most important parts of a company’s success for multiple reasons. Firstly, it influences the return a company earns for its shareholders. If a company chooses to issue more shares and profit levels are maintained, the earnings-per-share (EPS, calculated by dividing income by the number of shares) would decrease because the same income is being divided up among more shares. This is an important consideration to be made because EPS is a popular metric used by investors to see if a share is worth purchasing or not. Therefore, by decreasing the EPS, a company could potentially seem less attractive to an investor which is the opposite of what a company wants.
Additionally, the capital structure of a company is a key point of analysis to see how a company would perform in the event of a market downturn or a recession. A company laden with debt is likely to struggle in the event of a downturn because sales may stall, meaning there is less cash flowing into the company and so paying creditors is more difficult. Consequently, bankruptcy may end up a more likely possibility. Similarly, an equity-heavy company struggling as a result of market conditions is also likely to experience uncertainty where shareholders are pulling out of the market, decreasing the overall level of investment in the company. Without sufficient investment, the company may struggle to meet its day-to-day costs (let alone finance future growth opportunities) which could lead to the gradual demise of the company.
Current Trends in Capital Structure
In order to look at the current trends in Capital Structure, we are best positioned to look at the bond and equity markets to gauge market sentiment. In a year unforeseen by all, the structure of companies has never been so important.
So far in 2020, the bond markets have been flooded with new debt. The COVID-19 pandemic has led to an overhaul in government stimulus packages as they looked to prop up the economy and financial markets. $525B worth of new debt has been created in Europe whilst new debt deals in the US have topped $1.2T [1]. This sends a clear message to the market that companies are looking to have sufficient cash on hand to fuel business and also to ‘ride the wave’ that the pandemic has caused in the global economy. The pandemic may have also led to an increase in bond values as falling dividends for some firms have meant investors look for alternate avenues of consistent income.
With bond markets flourishing, the fortunes of the equity markets are also beginning to turn. Despite market hysteria wreaking havoc earlier on in the year, 477 IPOs went ahead in Q3 topping the number of IPOs in Q1 and Q2 combined. Evidencing a clear desire of some firms to still go to market, the level of share offerings looks to continue into Q4 though the dark clouds of the US election and the possibilities of more lockdowns potentially put this scenario in jeopardy. [2]
Is There an ‘Optimum’ Capital Structure?
Evidently, the COVID-19 pandemic has led to changes in the capital structure of many firms. Over the past hundred years or so, there has been a huge topic of debate over whether or not there is an ‘optimum’ capital structure that a company should take in order to achieve the most they can, whilst also taking on as least risk as possible. Whilst many academics have seemingly found this equilibrium (where a firm’s Weighted Average Cost of Capital, aka WACC, is minimised), the consensus remains that it is up to financial managers and strategists to make such a decision. This is mainly due to the drawbacks of debt and equity that are sometimes ignored in these models made by academics. Debt may be easier to obtain than equity but also has colossal costs involved in the event of a loan default or bankruptcy. Likewise, the cost of issuing equity can be enormous with the average cost of an IPO coming between $8.2M and $25M, making obtaining equity harder. [3] With that said, the hunt for an ‘optimum’ capital structure will continue though, in the modern-day, it seems like it is up to the discretion of managers to decide how debt and equity make up their company.
In summary of such a vast topic, the capital structure of a company is one of the most pivotal decisions that can be made by financial managers. As seen over the past year, the state of the global economy and market conditions can change at any time and so it is ever-more important that a balance is made between debt and equity which permits success in the biggest way possible whilst limiting the effect of crises.