Capital Structure

Capital structure: the proportion of debt to equity making up the total finance supplied to the company.

The shareholders in a company such as XYZ Ltd may be more than happy for the company to borrow some funds either from a bank or a bond issue due to the leverage (or gearing) effect. To understand this, imagine that the firm is now 5 years old and has long since paid off all its bank borrowings. It has proposed a major new investment in branch lines that will require US$5 million of new investment. It could go to its shareholders, selling them additional shares through a rights issue (more about this later) to obtain all the extra US$5 million from them. But consider this: the investment is expected to produce a return of 20 per cent per year on the money invested: £1 million per year on the £5 million raised from the shareholders. This is good, but the shareholders could be made even better off by an alternative capital structure.! If the company obtained US$1 million from equity holders and US$4 million from bondholders it could generate much higher returns for its shareholders. If we assume that bondholders require a return of 6 per cent per year, then the benefit of financial leverage to shareholders can be seen. The company creates US$1 million of extra pre-interest income per year. Of that US$240,000 (6 per cent of US$4 million) has to go to pay the interest on bonds. That leaves US$760,000 per year for the equity holders, who only put up an extra US$1 million - a 76 per cent return per year!

Not bad. But there is a downside to financial leverage. A company can have too much debt, too many regular interest payment commitments, so that it cannot survive a decline in its underlying business. By borrowing more it adds to its fixed costs (the extra interest each year), and a couple of years of losses can wipe out the net assets and force liquidation. However, in the case of XYZ Ltd there is little need to worry. Balance sheet net assets after 5 years of operating now stand at US$10 million and revenues are still growing. Debt of US$4 million and annual interest of US$240,000 should not be too much of a problem.