What is Capital Structure and good Capital Structure?

The term capital structure refers to the mix of different types of funds which a company uses to finance its activities. 

In summary, we often assume that companies are financed by just two types of funds, shareholders funds (equity) and borrowings (debt), and we will consider the effect on the cost of capital of varying the proportion of debt in the capital structure.

那么，有人會問什么是一個很好的資本結構。對于公司來說，一個好的資本結構是導致資本的公司以回報較低的整體速度進行回報，并且在此情況下對提供的資金支付較低的總體成本。如果資本成本低，再由本公司產(chǎn)生未來現(xiàn)金流量的折現(xiàn)值高，造成了高公司整體價值。因此，我們的目標是找到資本結構，給出了最低的資本總成本，因此，這種狀態(tài)就是該公司的最高值。

Then, somebody will ask what is a good capital structure. so a good capital structure is a capital structure which results in a low overall cost of capital for the company that is a low overall rate of return that needs to be paid on funds provided. If the cost of capital is low, then the discounted value of future cash flows generated by the company is high, resulting in a high overall company value. The objective is therefore to find the capital structure that gives the lowest overall cost of capital and, consequently, the highest company value.

Effects of borrowing借貸的影響
 

Suppose our company is financed entirely by ordinary shares (equity). What would be the effects of issuing some debt capital? Following we have identified two distinct advantages and two distinct disadvantages The main advantage of borrowing is that debt has a cheaper direct cost than equity. There are two distinct reasons for this: 

1.debt is less risky to the investor than equity (low risk results in a low required return); 

2.interest payments are allowable against corporate taxation, whereas dividends are not.

However, borrowing has two distinct disadvantages. 
 

We can discuss in detail following for the disadvantages:

1. it causes shareholders to suffer increased volatility of earnings. This is known as financial leverage. For example, if a firm is financed entirely by equity, a 10% reduction in operating earnings will result in a 10% reduction in earnings per share. But if the firm is financed by debt as well as equity, a 10% reduction in operating earnings causes a greater reduction in earnings per share than 10%, because debt interest does not reduce in line with operating earnings. The increased volatility to shareholders’ returns resulting from financial leverage causes shareholders to demand a higher rate of return in compensation. In other words, any borrowing at all will cause the cost of equity capital to rise, off-setting the cheap direct cost of debt.#p#分頁標題#e#
 

2.The second disadvantage of borrowing is that if the company borrows too much, it increases its bankruptcy risks. At reasonable levels of gearing this effect will be imperceptible, but it becomes significant for highly geared companies and results in a range of risks and costs which have the effect of increasing the company?s cost of capital. 

We also can use the table following to talk ahout:

 

1. Cheap direct cost because debt is less risky to the investor 1. Financial leverage causes shareholders to increase their cost of capital

2. Cheap direct cost because interest is a tax deductible expense. 2. Bankruptcy risks if borrowings are too high

When you invest in a company, you need to look at many different financial records to see if it is a worthwhile investment. But what does it mean to you if, after doing all your research, you invest in a company and then it decides to borrow money? Here we take a look at how you can evaluate whether the debt will affect your investment.

How Do Companies Borrow Money?公司如何借錢？

There are two main methods by which a company can borrow money: (1) by issuing fixed-income (debt) securities - like bonds, notes, bills and corporate papers - and (2) by taking out a loan at a bank or lending institution.

Fixed-Income Securities - Debt securities issued by the company are purchased by investors, so, when you buy any type of fixed-income security, you are in essence lending money to a business or government. When issuing these securities, the company must pay underwriting fees. However, debt securities allow the company to raise more money and to borrow for longer durations than loans typically allow. 
 

Loans - Borrowing from a private entity means going to a bank for a loan or a line of credit. Companies will commonly have open lines of credit from which they may draw in order to meet their cash requirements of day-to-day activities. The loan a company borrows from an institution may be used to pay for the company payrolls, buy inventories and new equipment, or to keep as a safety net. For the most part, loans require repayment in a shorter time period than most fixed income securities. 

Is there an optimal debt-equity relationship? 
 

In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. #p#分頁標題#e#

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

How to evaluate a company’s capital position如何評估一個公司的資本狀況

Capital structure varies greatly from one company to another. For example, some companies are financed mainly by shareholders? funds whereas others make much greater use of borrowings. In this article we consider some of the arguments that have been put forward in answer to the question ? Are some capital structures better than others? 

In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position.

The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities.

The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt. 

Is there an optimal debt-equity relationship? 

In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. 

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

   
Conclusion結論

    A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of investment quality.