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.