INVESTOR EDUCATION – Capital Structure
In this article reviews the different forms of capital that a company can use and the implications of
using this form of capital. We explain the difference between debt and equity and the advantages and
disadvantages of using each form.
Debt vs Equity – Investors choice
Debt and equity are forms of capital that a company uses to raise cash to fund the assets and operations of its business. If the company’s current retained profits are insufficient to fund its future projects it will often issue capital in order to raise the money it requires.
Debt
Debt is a contractual arrangement in which a company borrows money from a lender for a pre-defined period of time. The company pays periodic interest payments to the lender as a form of compensation for use of the capital. At the end of the loan, the capital is returned to the lender.
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Put summary note
Often the company’s debt is referred to as its ‘financial leverage’. High financial leverage implies that the company has a high proportion of debt relative to its available capital. As the company’s financial leverage increases, it is said that financial risk also increases. This is because it becomes more and more difficult to ensure its interest payments will be meet as they will be a lot larger and onerous with more debt.
Equity
Equity is a claim on a company’s assets after all other fixed obligations have been meet. There is no guaranteed return on the capital nor is there a guarantee that the original capital be repaid. However, shareholders enjoys any future profits the assets of the company generates after its obligations have been repaid. The shareholders are generally rewarded by dividends and capital gains. Dividends are profits that the company has earned and no longer requires. The company returns this unneeded cash to shareholders. Dividends are not guaranteed and therefore management have no obligations to pay them.
Capital gains occur with the value of the firm’s assets go up. Because with equity, the holder has an ownership stake in the company’s assets, as the value of the assets rise so does the value of their shares.
Investors
Buying bonds in a company means that as an investor you will receive a fixed payment on a pre-defined basis. At expiry of the bond, the company will repay you the principal it was lent it. Importantly, if the company runs into financial difficulty, you are repaid first out of the value of the company’s assets before equity holders receive anything.
When an investor buys shares, they are buying a slice of ownership of the company’s assets. The equity holder receives voting rights which they are able to use to influence the direction of the company. You may receive dividends if there are excess profits.
The amount of the dividend varies dependent upon how much profit the company
generates. As a shareholder you own a stake in the company and as the value of the company’s
assets rise the value of your shares also increase. This is known as capital gains.
However, should the company fall into bankruptcy, there is no guarantee that your
original investment will be repaid. Equity holders receive any value that is left from the
assets after all other obligations of the company have been meet.