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
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Actually, equity financing could be expensive for some companies. This is because shareholders usually require a high rate of return and expect to receive dividend income from the company. Moreover, equity financing is not tax deductible (since there is no interest expense), so companies don’t benefit like they do when they are financed through debt. Also, when companies issue more equity, the earnings per share go down, which usually leads to a fall in the share price.
In order to summarize, one could say that there are different approaches to capital structure – some companies prefer to issue more debt, because it is cheaper than equity, while others prefer to issue shares and finance themselves through equity, which makes them less risky (low gearing ratio), but at the same time it is more expensive and they can’t benefit from tax advantages.
In fact, leverage benefits investors. However, their expected return rises with the level of gearing a company has, because of the higher risk.
Generally, large companies have a greater borrowing ability because of their strong streams of income and ability to make their interest payments. However, what usually happens is that small companies are the ones that issue more debt, even though their borrowing
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