Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.
Equity capital represents money put up and owned by shareholders. This money can be used to fund projects and other opportunities under the auspice of creating greater value. This type of capital is typically the most expensive. In order to attract investors, the firms expected returns must consummate with the associated risk ("Financial leverage and,"). To illustrate this, consider a speculative oil drilling operation, this type of operation would require higher promised returns than say a Wal-Mart in order to attract investors. The two primary forms of equity capital are 1) money invested into the business for an ownership stake (i.e. stock) and 2) retained earnings from past profits used to fund future growth through acquisitions, expansions and product development.
Debt capital refers to money borrowed. Examples of this include bonds and short-term commercial paper. Bonds are more widely used because it provides a company with years to come up with the principal while paying interest only. Bonds are rated (i.e. AAA, AA, BB, etc.), these ratings correspond to the risk of default. The higher the rating, the lower likelihood of default and therefore a lower interest rate accepted by the lender. Short-term commercial paper is typically...
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...t the overall WACC. It will change the risk premium expected by equity holders. Less debt equates to a lower risk premium versus greater debt.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Financial leverage and capital structure policy - capital structure Investopedia, Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/capital-structure.aspx
Morningstar. (2014, March 10). Retrieved from http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=HD&Country=usa
Yahoo finance. (2014, March 10). Retrieved from http://finance.yahoo.com/q;_ylt=AhzwS2Csrl01Nl5OggYZa2eiuYdG;_ylu=X3oDMTBxdGVyNzJxBHNlYwNVSCAzIERlc2t0b3AgU2VhcmNoIDEx;_ylg=X3oDMTBybHFhOHFvBGxhbmcDZW4tVVMEcHQDMgR0ZXN0AzUxMjAxNQ--;_ylv=3?uhb=&fr=uh3_finance_vert_gs&type=2button&s=HD
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