Capital structure describes how a corporation has organized its capital—how it obtains the financial resources with which it operates its business. Businesses adopt various capital structures to meet both internal needs for capital and external requirements for returns on shareholders investments. As shown on its balance sheet, a company's capitalization is constructed from three basic blocks:
Long-term debt. By standard accounting definition, long-term debt includes obligations that are not due to be repaid within the next 12 months. Such debt consists mostly of bonds or similar obligations, including a great variety of notes, capital lease obligations, and mortgage issues. Preferred stock. This represents an equity (ownership) interest in the corporation, but one with claims ahead of the common stock, and normally with no rights to share in the increased worth of a company if it grows. Common stockholders' equity. This represents the underlying ownership. On the corporation's books, it is made up of: (I) the nominal par or stated value assigned to the shares of outstanding stock; (2) the capital surplus or the amount above par value paid the company whenever it issues stock; and (3) the earned surplus (also called retained earnings), which consists of the portion of earnings a company retains after paying out dividends and similar distributions. Put another way, common stock equity is the net worth after all the liabilities (including long-term debt), as well as any preferred stock, are deducted from the total assets shown on the balance sheet. For investment analysis purposes, security analysts may use the company's market capitalization—the current market price times the number of common shares outstanding—as a measure of common stock equity. They consider this market-based figure a more realistic valuation.
CHOOSING DEBT VERSUS EQUITY
It should be noted that companies may operate without funded debt or, more frequently, without any preferred stock. By the very nature of corporate structure, however, they must have common stock and the related stockholders' equity account—though, when the company fares badly, the equity can be a negative amount.
In arranging a company's financial structure, management normally aims for the lowest feasible cost of capital; whereas an investor seeks the greatest possible return. While these desires can conflict, they are not necessarily incompatible, especially with equity investors. The cost of capital can be kept low and the opportunity for return on common stockholders' equity can be enhanced through leverage—a high percentage of debt relative to common equity. But increased leverage carries with it increased risk. This is the inescapable trade off both management and investors must factor into their respective decisions.
The leverage provided by debt financing is further enhanced because the interest that corporations pay is a tax-deductible expense, whereas dividends to both preferred and common stockholders must be paid with after-tax dollars. Thus, it is argued, the lower net cost of bond interest helps accrue more value for the common.
But, of course, increased debt brings with it higher fixed costs that must be paid in good times and bad, and can severely limit a company's flexibility. The Financial Handbook, spells out four problems that tend to increase as leverage escalates: (1) a growing risk of bankruptcy; (2) lack of access to the capital markets during times of tight credit; (3) the need for management to concentrate on finances and raising additional capital at the expense of focusing on operations; (4) higher costs for whatever additional debt and preferred stock capital the company is able to raise. Aside from the unpleasantness involved, it is noted that each of these factors also entails tangible monetary costs.
Still, because of its tax advantages and stability relative to equity capital (common stock), some finance theorists have...
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