Capital Structure of Company

Every company needs capital to operate, this capital can be either from equity (net assets of the firm) or debt (borrowed from banks or by issuing bonds). But how does the management of a company decide whether it should take on debt or completely depend on its investors' money. To understand the implications of deciding on a particular capital structure we need to understand what the two sources of capital expect in return.

When a company takes on a debt it has a contractual obligation to pay the lender this implies that the lender has to face very little risk and is guaranteed his return. On the other hand the investors of a company only get paid dividends if the company turns a profit and even then only after the company has paid interest and taxes. This means that the investors put their money under more risk than the lenders and hence they expect higher return than the lenders. This is why cost of capital form the investors is greater than the cost of capital from the lenders.

So this means that the company should take on as much debt as possible right? According to the Modigliani-Miller Theorem the cost of capital will not change as a company with more debt is riskier to invest in and thus the investors will also expect greater returns which would effectively keeping the average cost of capital constant. So this would mean that financially the only factor that determines a company's capital structure should be its debt capacity. Although debt capacity is a major factor we forgot to account for the fact that interest paid to lenders is not taxed.

But debt comes at a much higher cost, what if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow.

At the end of the day, be it equity or debt, it all boils down to the same thing golden rule: "There is no such thing as a free lunch!"