Capital Structure Of Debt And Equity

1607 Words Nov 30th, 2015 7 Pages
I. Capital Structure Overview

The capital structure refers to the proportion of debt and equity by which a company is financed. In fact, shareholders are the ones that provide the company with equity financing, whereas bond investors and banks provide it with debt through bonds and loan contracts.
Actually, it could be an issue for a company to decide on an optimal debt to equity mix, and there are a few different theories that explain that. Here, it is important to say that an optimal debt to equity mix could be different for companies in different sectors, and there are advantages and disadvantages of using debt and equity. Therefore, each company needs to decide on what proportion of debt and equity to use in order to maximise its value.

As already mentioned, both debt and equity have their advantages and disadvantages. The advantages of debt financing are:
• The interest rate is usually lower than the rate required by the shareholders
• Debt interest is tax deductible
• Administrative and issuing costs are typically lower (sometimes underwriters are not required)
Moreover, an interesting point has been made that a way to introduce discipline to the investment process is by encouraging firms to borrow money. The reason for this is because borrowing creates a commitment for making interest payments, which increase the default risk on projects. Therefore, the discipline of debt helps managers to make better financing decisions in order to be able to make those…
Open Document