QUESTION : HOW CAN A FIRM MAKE ITS CAPITAL

STRUCTURE EFFECTIVE ?

CAPITAL STRUCTURE –

1. The capital structure is the particular combination of Debt

and Equity.

2. Capital structure is how a company funds its overall

operations and growth.
3. Debt consists of borrowed money that is due back to the
lender, commonly with interest expense.
4. Equity consists of ownership rights in the company, without
the need to pay back any investment.
5. The Debt-to-Equity (D/E) ratio is useful in determining the
riskiness of a company's borrowing practices.

Debt and equity capital are used to fund a business’s

operations, capital expenditures, acquisitions, and other
investments. There are tradeoffs firms have to make when
they decide whether to raise debt or equity, and managers will
balance the two to find the optimal capital structure.

OPTIMAL CAPITAL STRUCTURE –

The optimal capital structure of a firm is often defined as the

proportion of debt and equity that results in the lowest cost of
capital for the firm.
 Risk Return

Debt Low risk Low return

a. Interest
b. Capital back

Equity High risk High return

a. Dividend
b. Capital
growth

To understand capital structure better we

must know the pros and cons of equity and
debt

Pros and cons of equity:

 No interest payments
 No mandatory fixed payments (dividends are
discretionary)
 No maturity dates (no capital repayment)
 Has ownership and control over the business
 Has voting rights (typically)
 Has a high implied cost of capital
 Expects a high rate of return (dividends and capital
appreciation)
 Has last claim on the firm’s assets in the event of
liquidation
  Provides maximum operational flexibility

Pros and cons of debt:

 Has interest payments (typically)
 Has a fixed repayment schedule
 Has first claim on the firm’s assets in the event of
liquidation
 Requires covenants and financial performance metrics
that must be met
 Contains restrictions on operational flexibility
 Has a lower cost than equity
 Expects a lower rate of return than equity

How to Choose Between Debt and Equity

The amount of money that is required to obtain capital from
different sources, called cost of capital, is crucial in determining
a company's optimal capital structure. Cost of capital is
expressed either as a percentage or as a dollar amount,
depending on the context.

The cost of debt capital is represented by the interest rate

required by the lender. A $100,000 loan with an interest rate of
six percent has a cost of capital of six percent, and a total cost
of capital of $6,000. However, because payments on debt are
tax-deductible, many cost of debt calculations take into account
the corporate tax rate.

Assuming the tax rate is 30 percent, the above loan would have
an after-tax cost of capital of 4.2%.

Cost of Equity Calculations

The cost of equity financing requires a rather straightforward
calculation involving the capital asset pricing model or CAPM:
CAPM= Risk Free Rate /(Company’s Beta × Risk Premium)

By taking into account the returns generated by the larger

market, as well as the individual stock's relative performance
(represented by beta), the cost of equity calculation reflects the
percentage of each invested dollar that shareholders expect in
returns.

Finding the mix of debt and equity financing that yields the best
funding at the lowest cost is a basic tenet of any prudent
business strategy. To compare different capital structures,
corporate accountants use a formula called the weighted
average cost of capital, or WACC.

The WACC multiplies the percentage costs of debt—after

accounting for the corporate tax rate—and equity under each
proposed financing plan by a weight equal to the proportion of
total capital represented by each capital type.

This allows businesses to determine which levels of debt and

equity financing are most cost-effective.

Why debt is better than equity

1. In the long run, debt is cheaper than equity

Entrepreneurs tend to think of VC as free money. It’s not. In

fact, if you plan to scale and exit, debt is almost always the
cheaper option.

Think of it this way. If you take a five-year loan of $1M at 20%

APR, that $1M has cost you $1.6M by the time you pay it off.
But if you take $1M from a VC at a $5M valuation (meaning you
sell 20% of your equity), then get acquired for $15M, those VCs
get $3M.

The same amount of capital at the same time, but the lender
sells you $1M for $1.6M, and the VC sells you $1M for $3M.

2. Debt gives you tax benefits

Assuming your company is out of the red, debt financing

provides a few tax perks that equity financing cannot.

If your business uses accrual accounting, the interest portion

of your payment runs through your profit and loss statement,
which reduces your taxable net income. This means the
effective cost of the borrowing is less than the stated rate of
interest. Essentially, the US government helps mitigate the
cost of your loan.

3. A lender isn’t going to tell you how to run your business

Taking on equity investors means giving them seats on your

board. It also means conforming to their expectations of how
your company should grow. If you don’t like it, be careful—they
can limit your control over the business you started, or, in the
worst-case scenario, oust you from your own company.

Lenders don’t worry as long as you’re hitting your payments

and staying in a position to continue doing so. No board seats,
no control.

4. For businesses with sticky revenue streams, debt can be

very accretive

Jason Lemkin points out that if you’re an early-stage company

with recurring revenue streams (like SaaS or subscription-
based services), a minor amount of debt will actually increase
your net cash flows. The extra cash will let you make a few
key hires. If you hire well, those folks will build out features
and sales programs and you can see an ROI much higher than
the cost of their salaries.

5. More time to actually run your company

Raising a VC round usually takes between six and nine months

of coffee meetings, pitches, and phone calls. Raising debt
financing is generally much faster. Lighter Capital, where I
work, often funds companies in one month.

Debt saves you time once you get it, too. Lenders don’t need to
keep up with your every decision, and they don’t require board
meetings. They won’t need to deliberate with you over every
new hire or strategy.