What is Capital Structure?

Capital structure is how a company pays for what it needs to run its business. It’s the mix of different kinds of borrowed money (debt) and ownership (equity) that a company has. Companies raise money from lenders and owners to buy things like buildings, equipment, and supplies. The money a company gets is listed on the right side of its balance sheet.

Debt and Equity

There are two main ways a company gets money: debt and equity.

Debt

Debt is money a company borrows. The company promises to pay back this money, plus extra (called interest). There are different kinds of debt:

Bonds: A bond is when a company borrows money from lots of people. The company sells bonds to get cash. It promises to pay back the money plus interest.
Bank Loans: A company can also borrow money from a bank. The bank will want collateral (like property) in case the loan isn’t paid back.
Notes Payable: This is a written promise by the company to pay someone back. It works like an IOU.

Companies have to pay back debt, even when times are tough. This is risky. But debt is often cheaper than equity. Interest paid on debt can also lower taxes.

Equity

Equity is ownership in the company. When people buy equity (also called stock or shares), they become part owners. There are two main types:

Common Stock: This is the most basic type of ownership. People with common stock can usually vote on big company decisions.
Preferred Stock: This type of stock usually doesn’t come with voting rights. But it often pays a set amount to owners each year. Preferred stock owners are paid before common stock owners if the company fails.

Companies don’t have to pay equity owners, so equity is less risky than debt. But giving away ownership means the original owners have less control.

Capital Structure Decisions

Managers decide on the best mix of debt and equity for their company. They think about:

Risk: More debt means more risk. The company has to make payments, even in bad times. But more equity means the original owners lose some control.
Cost: Debt is often cheaper than equity, especially when interest rates are low. But equity can be better in the long run because the company doesn’t have to pay it back.
Taxes: Interest on debt can be subtracted from taxes. Dividends paid to equity owners can’t. So debt can lower a company’s taxes.
Control: The original owners may not want to give up control by selling equity. Using debt lets them keep control.

The right mix depends on the company and industry. Young, risky companies often use more equity because they can’t get much debt. Stable companies with steady income can use more debt.

Changing the Capital Structure

Companies can change their capital structure by:

Issuing Bonds: Selling bonds raises debt. The company gets cash but has to make payments in the future.
Issuing Stock: Selling new shares raises equity. The company gets cash and doesn’t have to pay it back. But it means sharing ownership.
Paying Off Debt: Using cash to pay back debt lowers the amount of debt in the capital structure.
Buying Back Stock: Using cash to buy back shares lowers the amount of equity.

Managers change the capital structure when they think it will help the company. For example, a company may issue bonds if interest rates are low and it needs cash for a new project. Or it might buy back stock if managers think the share price is too low.

The Goal of Capital Structure

The main goal of capital structure decisions is to lower a company’s cost of capital. This is the average cost of all of its debt and equity. A lower cost of capital means the company’s projects are more profitable.

Managers also want a capital structure that helps the company survive tough times. Too much debt is risky when sales are down.

In the end, the right capital structure is the one that helps the company the most in the long run. It’s a balance between risk and reward. Smart capital structure decisions can make a company more competitive and profitable.