Capital Structure
You need money to buy a house. The bank won't give you a loan (the result of some pesky details surrounding a land deal in Florida from a while back...no need to tell the whole story here). So now what? Wouldn't it be great if there was another option? What if you could sell stock in yourself, the way companies do? (That Florida land thing might come up there too, but you can take your chances.)
If you went public, you might not get too many buyers, but companies usually do. The fact that companies can raise funds by selling stock on the public market gives them a choice. They can choose between debt and equity (and usually use a combination of the two) in order to finance daily operations and to expand their business. This is known as their capital structure. It's the way a company has financed itself.
A given company might have $800M in debt, while raising $250M in equity and have $300M in cash on their books. Meanwhile, it has other assets, like a factory worth $425M after having been depreciated from $800M and patents worth $100M. The debt could be in the form of bank loans or it could come from issuing bonds. Equity would include common and preferred stock.
The trick in optimizing the capital structure is to find the right mixture of debt and equity, remembering that when you sell debt, you have to pay it off at some point (presumably). When you sell equity, on the other hand, you've sold ownership in yourself forever.
The right mix in the capital structure varies by context. The company's accountants and outside analysts often use a fairly simple comparison to study a company's capital structure. It's called the debt-to-equity ratio.
As the name implies, this figure provides the ratio between a company's debt and its equity. You calculate this by dividing the firm's total debt by its total equity.
One of the benefits of debt is that interest payments are tax deductible. You also don't have to give up any company ownership like you would with selling stock. With equity, you don't have to pay any money back like you would with a loan or bond issue, but you give up a piece of ownership in the company.
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finance a la shmoop- what is compounding value or compounding interest? ah the
power of compounding. it makes trees stronger pollution more feral and the
rich well richer. how so well let's start with compounds kissing
cousin with six toes, arithmetic compounding. right so the first was [feet with six toes pictured]
really geometric compounding now we're talking about arithmetic compounding. if
you invest a thousand bucks in a ten-year bond that pays 6% of a year in
interest, the dough comes back to you in a pattern that looks like this - like
every six months they pay thirty bucks and it's $60 a year, got it? nice. you get
the total of sixteen hundred bucks back from your investment and the cash that
came back to you you know came in small parts all along the way, until you got [list of yearly returns]
about two thirds of it or sixty percent at the end right? if you just spent that
money and collected your thousand bucks at the end that's it. okay so that's
arithmetic compounding/ the money comes to you if you don't reinvest it.
ding-ding-ding that's the key here and you just go buy burgers. okay so now
let's look at what six percent compounded looks like over the same
10-year period .well at the end of year one it's a thousand sixty bucks and note
we're only gonna compound it annually we probably should do the semi-annually but [list of yearly compounds]
we'd confuse you even more so don't do that. but then you essentially reinvest
that money and you get another six percent compounded on that thousand
sixty , instead of six percent compounded against the original thousand. so by the
end of year two you'll have a thousand one hundred twenty three sixty. and by
the end of year ten you'll have one thousand seven hundred and ninety
dollars and eighty-five cents. so why do you make so much more money when you
compound interest versus getting 30 bucks twice a year like you would in
this bond example? go and find burgers with it? yeah .you don't want to do that
well essentially what's happening is that you're delaying your gratification [man in a drive through window]
of getting that sweet sweet cash or getting liquid whatever you want to call
it. by reinvesting your gains year after year after year. so do you have that sort
of self-control? do you need the cash yeah that's the question if you for
example have trouble making it home from your local pizza spot with the pie
in tact well then compound interest keeping the discipline to not spend the [man eats pizza while driving]
money today and wait for the happiness tomorrow well when that may not be for
you. sorry
Up Next
What is recapitalization? Pay attention the first time, there won't be a recap.