Capital Structure, Level I
2022 Curriculum CFA Program Level I Corporate Finance
Capital StructureDownload the full reading (PDF)
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Capital structure refers to the specific mix of debt and equity used to finance a company’s assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility. Debt, on the other hand, represents a cheaper, finite-to-maturity capital source that legally obligates the company to fixed, promised cash outflows with the need to refinance at some future date at an unknown cost.
A company’s capital structure is the result of such financing decisions that may be guided by capital structure policies or targets set by management and the board. Capital structure is also the result of such factors as company size and maturity, which influence the financing options a company may have available. Besides equity and debt issuance, capital structure can also be significantly affected by merger and acquisition (M&A) activity, which can be financed by cash, borrowing, share assumption and/or debt assumption in addition to proceeds from divestitures and asset sales. Capital structure is also affected over time by the company’s operations, which might consume or generate cash, and by management decisions regarding dividends and share buybacks.
Since we are considering how a company minimizes its overall cost of capital, the focus here is on the market values of debt and equity. Therefore, capital structure is also affected by changes in the market value of a company’s securities over time, particularly the share price.
We tend to think of capital structure as the result of a conscious decision by management, but it is not that simple. For example, unmanageable debt, or financial distress, can arise because a company’s capital structure policy was too aggressive, but it can also occur because operating results or prospects deteriorate unexpectedly.
This reading reviews some of the key factors affecting capital structure, including the following:
- Company life cycle: Companies typically evolve over time from cash consumers to cash generators, with decreasing business risk and increasing debt capacity.
- Cost of capital: From a theoretical perspective, company management seeks to maximize shareholder value and determines an optimal capital structure to minimize the company’s weighted average cost of capital (WACC). “Optimal capital structure” involves a trade-off between the benefits of higher leverage, which include the tax deductibility of interest and the lower cost of debt relative to equity, and the costs of higher leverage, which include higher risk for all capital providers and the potential costs of financial distress.
- Financing considerations: From a practical perspective, company management may consider several factors in capital structure decisions and the use of leverage.
- Competing stakeholder interests: In seeking to maximize shareholder value, company management may make capital structure decisions that are not in the interests of other stakeholders, such as debtholders, suppliers, customers, or employees.
The member should be able to:
- describe how a company’s capital structure may change over its life cycle;
- explain the Modigliani–Miller propositions regarding capital structure;
- describe the use of target capital structure in estimating WACC, and calculate and interpret target capital structure weights;
- explain factors affecting capital structure decisions;
- describe competing stakeholder interests in capital structure decisions.
- A company’s stage in the life cycle, its cash flow characteristics, and its ability to support debt largely dictate its capital structure since capital not sourced through borrowing must come from equity (including retained earnings).
- Generally speaking, as companies mature and move from start-up, through growth, to mature, their business risk declines as operating cash flows turn positive with increasing predictability, allowing for greater use of leverage at more attractive terms.
- Modigliani and Miller’s work shows us that managers cannot change firm value simply by changing the firm’s capital structure. Firm value is independent of the capital structure decision.
- Given the tax deductibility of interest, adding leverage increases firm value to a point but also increases the risk of default for capital providers who demand higher returns in compensation.
- To maximize firm value, management should target the optimal capital structure that minimizes the company’s weighted average cost of capital.
- In practice, financing decisions are typically tied to investment spending and based on the company’s ability to support debt given the nature of its business and operating cash flows.
- Managers may provide investors with information (“signaling”) through their choice of financing method. For example, commitments to fixed payments can signal management’s confidence in the company’s future prospects.
- Management’s capital structure decisions impact various stakeholder groups differently. In seeking to maximize shareholder wealth or their own, conflicts of interest may arise in which one or more groups are favored at the expense of others.