Capitalization
The next topic of discussion in our finance section is the internal financial structure and management of the company.
Capitalization is the amount or value of assets in a business. These assets are generally employed within or to fund business operations.
What is Capital?
In this context of capitalization, “capital” refers to the amount of money available to a company; including all monies contributed by owners/shareholders (shareholder’s equity) or retained from operational revenue (retained earnings), and obtained from loans or issuing corporate bonds (debt).
What is Capital Structure?
The capital structure or financial structure is the unique combination of debt and equity (sale or issuance of shares) used to finance operations. Restated, it is the means through which a company pays for operational costs or expansion. This is done through taking out loans or the issuance or sale of shares of stock in the company.
Decisions about the appropriate capital structure is thus a decision of whether to issue equity or incur debt. Let’s dig into this decision a bit further.
Debt Capital vs. Equity Capital
When firms have to make tradeoffs, they usually decide whether to raise funds from equity (investments), debt (loans or bonds), or some combination of the two. In this case, it is the duty of managers to ensure that they balance the two to get a capital structure that is optimal.
Generally, companies use equity and debt to fund different business activities such as:
- Business operations
- Special projects
- Capital expenditures
- Acquisitions, including other investments.
Optimizing the capital structure means achieving a debt-to-equity ratio that is optimal for the firms creation of value or is in line with the average of the industry. Depending on the nature of the firm, the industry, and the future performance expectations, companies may pursue a higher or lower debt-to-equity ratio.
- Debt-to-Equity Ratio
The primary consideration for whether to incur debt is the interest to be paid on the debt. This is compared to the expected value to be gained by investing the loaned funds in a business project or operations.
The other consideration is what investors are willing to pay for a company’s shares based upon the expected future performance of the company. If shareholders expect an out-sized or extreme return on investment (such as payment of large dividends) it would make it beneficial to the company to pursue debt rather than equity investment.
- Note: The value of equity is the combination of shareholder’s equity (funds contributed from the issues of shares) and the retained earnings (revenue retained from operational activity – not distributed to company owners).
Why Do Companies Capitalize from a Combination of Debt and Equity?
It’s generally not a great idea to have a completely one-sided capital structure. When debt is a more advantageous means of financing operations, the company will buy back shares of ownership and incur more debt.
When debt is very expensive and investor demand for returns is lower, the company may finance operations through the sale of equity rather than debt.
Companies like issuing debt for various reasons:
- It provides companies with a tax advantage – as the payment of the interest on debt is tax-deductible.
- Unlike equity, debt allows the existing shareholders to retain a higher percentage of ownership in the company,
- When companies are experiencing low-interest rates, it is easy for them to access debt.
Equity capital, on the other hand, can be more expensive when you compare it to debt capital – especially when a company is experiencing low-interest rates in the market. What makes equity capital favorable is that unlike debt capital, companies are not obliged to pay back in case earnings happen to decline. That is, investors incur the risk. They are not ensured of a return in investment.