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101: Capital Structuring
Companies Served Since 1981

101: Capital Structuring


By Gregg Schoenberg Tuesday, March 12, 2013

A few months ago we ran a series of articles on HBS about various methods of raising capital for your business, from friends and family to angel investors, venture capitalists and crowd-funders. But no matter where you wind up raising your capital it will come in one of two forms: debt or equity. The choices you make between these two options will have profound effects on your profitability, tax liabilities, and ability to weather tough times, so let’s take a look a closer look at each one and examine a method for determining a company’s optimal capital structure.

Cost of Debt Capital

The concept of raising capital by issuing debt is fairly simple: you borrow money from someone—be it a bank, a family member, a credit card company, etc.—and agree to pay back the money plus a specified rate of interest. The interest rate represents the return that the lender receives on his investment, so you might think that it also equates to your cost for issuing the debt. But you’d be missing a very important characteristic of debt capital, and one that differentiates it from equity capital: the interest payments you make on your firm’s debt are tax-deductible. Mathematically speaking this means that your cost of debt is equal to the interest rate on the debt multiplied by one minus your tax rate or C=i(1-t). So if you issue debt at 10% and pay taxes at a 20% rate your cost of debt is actually 8%.

Cost of Equity Capital

If you’re raising capital via equity rather than debt, than you aren’t borrowing money from anyone and won’t be making any interest payments. Instead, you are selling an ownership stake in your company along with a corresponding claim on your firm’s future earnings.

While figuring out your cost of debt capital is pretty straightforward, the same cannot always be said for calculating the cost of issuing equity capital. MBAs and other finance professionals use a number of tools such as the capital asset pricing model (CAPM) and Dividend Discount Model (DDM) to help them make educated guesses but those models are fairly complicated and still imperfect so we won’t get into them here.

The important thing to remember is that the cost of equity capital is always higher than the cost of debt capital. There are two reasons for this: first, there is no tax-deduction for equity capital, and second, from the investor’s perspective, equity investments are riskier than debt investments because equity investors do not receive any interest payments in return for their capital and are subordinate to debt investors in the event of a bankruptcy. So equity investors will demand a higher rate of return than debt investors to compensate for this additional risk.

Determining the Optimal Capital Structure

Given that it is cheaper for a company to issue debt as opposed to equity you may be wondering why companies would ever to choose to issue equity. The answer lies in the relationship between the costs of debt and equity and their effect on a firm’s weighted average cost of capital (the total cost of capital based upon the proportions of debt and equity capital raised). A simple table can help exhibit this relationship.

 

ABC Corp’s Cost of Capital

 

Percentage of

Percentage of

Cost of

Cost of

Weighted Avg.

Debt Financing

Equity Financing

Debt Capital

Equity Capital

Cost of

Capital

0%

100%

4%

10%

10.00%

10%

90%

4%

10%

9.40%

20%

80%

4%

10%

8.80%

30%

70%

4%

10%

8.20%

40%

60%

4%

10.5%

7.90%

50%

50%

5%

11.5%

8.25%

60%

40%

6%

13%

8.80%

70%

30%

8%

15%

10.10%

80%

20%

10%

18%

11.60%

90%

10%

15%

22%

15.70%

 

If ABC Corp. doesn’t issue any debt then its cost of capital is equal to the cost of its equity capital, 10%.  But as it begins to issue debt at a cost of 4%, its weighted average cost of capital starts to decline. Up to a certain point. For ABC a mix of 40% debt and 60% equity results in the optimal (lowest) cost of capital of 7.90%. Above 40% debt, the cost of equity and debt capital starts to rise, leading to a higher overall cost of capital. The reasons behind this are pretty simple: if a company takes on too much debt then it increases the likelihood that it won’t be able to repay that debt, and it becomes a riskier investment for both debt and equity investors.

Hopefully this gives you a nice 101 on Capital Structuring; the differences between equity and debt capital and their impact on the total cost of capital. When it comes time to raise money for your firm, you may want to go into grater detail by reading more in a corporate finance textbook and consulting an investment-banking expert who can help determine your optimal capital structure.

 

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