Complete Guide To Corporate Finance

AAA

Financial Leverage And Capital Structure Policy - Introduction To Financial Leverage And Capital Structure Policy

Capital structure, the mixture of a firm's debt and equity, is important because it costs a company money to borrow. Capital structure also matters because of the different tax implications of debt vs. equity and the impact of corporate taxes on a firm's profitability. Firms must be prudent in their borrowing activities to avoid excessive risk and the possibility of financial distress or even bankruptcy.

A firm's debt-to-equity ratio also impacts the firm's borrowing costs and its value to shareholders. The debt-to-equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.




A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies tend to have a debt/equity ratio of under 0.5. (Read more in
Spotting Companies In Financial Distress and Debt Ratios: Introduction.) A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt. Issuing new debt increases the debt-to-equity ratio; issuing new equity lowers the debt-to-equity ratio.

As you will recall from Section 13 of this walkthrough, minimizing the weighted average cost of capital (WACC) maximizes the firm's value. This means that the optimal capital structure for a firm is the one that minimizes WACC.

In this section, we'll go into the details of a firm's capital structure, financial leverage, the optimal capital structure and real-world capital structures. We'll also talk about financial distress and bankruptcy, and Modigliani and Miller's ideas about capital structure and firm value when taking corporate taxes into account.

Capital Structure


Related Articles
  1. Professionals

    Bankruptcy Costs And Optimal Capital Structure

    We look at how debt and equity work together to form the optimal capital structure.
  2. Professionals

    Introduction To Cost Of Capital

    Cost of capital is very important for business budgeting and planning.
  3. Investing Basics

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  4. Bonds & Fixed Income

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  5. Professionals

    Capital Structure

    This is an important concept in valuing a company.
  6. Professionals

    Tax and Bankruptcy Costs

    CFA Level 1 - Tax and Bankruptcy Costs. Learn what effects taxes and bankruptcy costs have on capital structure. Contrasts the benefits of tax with the costs of possible bankruptcy.
  7. Investing Basics

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  8. Investing Basics

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  9. Professionals

    Extended Pie Model, Observed Capital Structures And Long-Term Financing

    We look at a number of different ways that companies are assembled through a mix of debt and equity.
  10. Investing Basics

    4 Leverage Ratios Used In Evaluating Energy Firms

    Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks.
RELATED TERMS
  1. Optimal Capital Structure

    The best debt-to-equity ratio for a firm that maximizes its value. ...
  2. Capitalization Ratios

    Indicators that measure the proportion of debt in a company’s ...
  3. Debt/Equity Ratio

    Debt/Equity Ratio is debt ratio used to measure a company's financial ...
  4. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  5. Capital Structure

    A mix of a company's long-term debt, specific short-term debt, ...
  6. Capitalization Structure

    The proportion of debt and equity in the capital configuration ...
RELATED FAQS
  1. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  2. How do bankruptcy costs affect a company's capital structure?

    Understand the Modigliani and Miller theory of capital structure. Learn how the theory shows how bankruptcy costs affect ... Read Answer >>
  3. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
  4. What debt to equity ratio is common for a bank?

    Take a look at the important debt-to-equity ratio, a key metric of financial leverage, and learn what the average debt/equity ... Read Answer >>
  5. How can I use the debt-to-capital ratio to evaluate a stock?

    Understand the significance of the debt to capital ratio of financial leverage, and learn how investors and analysts make ... Read Answer >>
  6. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>

You May Also Like

Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center