FINANCIAL MANAGEMENT

CHAPTER 7: CAPITAL STRUCTURE

Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and
finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other
investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and
managers will balance the two try and find the optimal capital structure.

The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The
safest type is generally considered long-term bonds because the company has years, if not decades, to come up
with the principal while paying interest only in the meantime.

Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital
consists of two types:

1. Contributed capital, which is the money that was originally invested in the business in exchange for
shares of stock or ownership.
2. Retained earnings, which represents profits from past years that have been kept by the company and
used to strengthen the balance sheet or fund growth, acquisitions, or expansion.

Optimal Capital Structure

The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the
lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in
practice, and firms often have a strategic or philosophical view of what the structure should be.
In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue whichever it
requires. The new capital that’s issued may be used to invest in new assets or may be used to repurchase
debt/equity that’s currently outstanding as a form or recapitalization.

Dynamics of Debt and Equity

Debt investors take less risk because they have the first claim on the assets of the business in the event of
bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a lower cost of capital
when it issues debt compared to equity.

Equity investors take more risk as they only receive the residual value after debt investors have been repaid. In
exchange for this risk equity investors expect a higher rate of return and therefore the implied cost of equity is
greater than that of debt.

How to recapitalize a business

A firm that decides they should optimize their capital structure by changing the mix of debt and equity has a
few options to effect this change.

Methods of recapitalization include:

1. Issue debt and repurchase equity - the firm borrows money by issuing debt and then uses all that
capital to repurchase shares from its equity investors. This has the effect of increasing the amount of
debt and decreasing the amount of equity on the balance sheet.
2. Issue debt and pay a large dividend to equity investors - the firm will borrow money (i.e. issue debt)
and use that money to pay a one-time special dividend, which has the effect of reducing the value of
equity by the value of the divided. This is another method of increasing debt and reducing equity.
3. Issue equity and repay debt - the firm moves in the opposite direction and issues equity by selling new
shares, then takes the money and uses it to repay debt. Since equity is costlier than debt, this approach is
not desirable and often only done when a firm is overleveraged and desperately needs to reduce its debt.
Cost of capital
A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known as the
weighted average cost of capital (WACC).

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

Assume a firm Photon limited that needs to raise capital to buy machinery, land for office space and recruit
more staff to conduct day to day business activities. Let’s say that the firm decided that it needs an amount of $
1 million for the same. The firm can raise capital through 2 sources – Equity and Debt.
 It issues 50,000 shares at $ 10 each and raises $ 500,000 through equity. As investors expect a return of
7 %, the cost of equity is 7 %.
 For the remaining $ 500,000, firm issues 5000 bonds at $ 100 each. The bondholders expect a return of
6%, hence Photon’s cost of debt will be 6 %.
 Additionally, let’s assume the effective tax rate is 35%.

Problem
As of October 2018, the risk-free rate, represented by annual return on 20-year treasury bond was 3.3 percent,
beta value for Walmart stood at 0.51, while the average market return, represented by average annualized total
return for the S&P 500 index over the past 90 years, is 9.8 percent.
From the balance sheet, the total shareholder equity for Walmart for the 2018 fiscal year was $77.87 billion (E),
and the long term debt stood at $36.83 billion (D).