Capital Structure

The mix of a companies Debt and Equity financing used to fund its assets.

Why do we care?

• Leverage (debt) can increase profitability, but also increases risk
• Importantly, it can affect firm value

Please read Capital Structure Irrelevance Principle and it’s impact at the end.

Capital Structure Checklist: FRICTO

Big picture question: Is there an optimal capital structure which maximizes market value for each firm?

Capital Structure Checklist:

• Flexibility: Does the structure allow for future financing needs?
• Risk: How does the debt level affect financial risk?
• Income/Return: How does financing impact returns to shareholders?
• Control: Examine ownership + covenants
• Taxes: Quantify value impact of tax shields
• Other: (market timing, signals)

Conclusion

• Leverage can increase ROE (as seen in M&M Theory)
• The tax shields from debt ate valuable to the firm
• But too much leverage can destroy firm value
• An “optimal” capital structure is about balancing the costs and benefits of debt