Capital Structure Decisions for Business Owners

Capital Structure Decisions for Business Owners

Capital structure is part of fundamental business strategy, and top-level driver for Financial Management. And every business owner/board should have a map for how capital will be obtained for various projects.

Capital structure decides what combination of debt and equity will be used to finance the business projects. And it thereby decides the value basic parameters like cost of capital, earnings per share and valuation.

Arriving at the capital structure will depend on multiple factors: owner/shareholder expectations, industry type, tax policy-high corporate rates favor debt, and overall corporate risk.

Assuming there are real projects to deliver real growth (an important assumption), then if company’s equity investors expect the stock to go up 10%+ per year, and if the company can borrow money at 6%, then the company should have some debt as a source of capital.

Now, the point to note here is that it will benefit the equity investors and share price to have some debt, but overuse of debt (over-leverage) is not healthy because it increases the risk in the company’s earnings stream, which in turn tends to lower the valuation and hence the share price.

Please note that Debt/Equity ratio is very important for financial stake holders of your business, and you must maintain a good interest coverage ratio.

So each business owner/board will have to find their zone of comfort and create a capital structure policy that makes a trade-off between risk and return, which is acceptable to all investors.

If need help with your capital structure planning, please contact us with your requirement.