Corporate Finance - Capital Structure

1. CORPORATE FINANCE
CAPITAL STRUCTURE
Dayana Mastura Baharudin

2. Capital Structure
• The capital structure of a company
refers to the mixture of equity and debt
finance used by a company

3. Disadvantages of debt finance compared to
equity
Disadvantages of debt Discussion
Debt creates higher variability in dividends
(higher financial risk)
If there is a downturn in business, there
will be a dramatic cut in the funds
available to pay dividend as there is a
need to pay interest first
The use of debt worsens interest cover
ratio and gearing ratio
Debt creates higher default risk which can
lead to financial distress
Debt payments must be made, even if a
business is not making profits
A key advantage of equity is that dividend
payments are at the discretion of the
Board

4. Advantages of debt finance compared to
equity
Advantages of debt Discussion
Debt is a cheaper source of finance Please refer to the creditor hierarchy
Debt has a better impact on earnings per share (EPS) Issuing new shares can be expected to have a more
dilutive effect on EPS than the issue of debt
Debt is quicker and cheaper to issue compared to a share
issue
Only true if comparing to a share issue. Equity may also
be source from internal finance
Interest repayments attract tax relief (ie reduce taxable
profit)
This is one of the key reasons why debt is a cheaper source
of finance
The use of debt is a discipline on management Careful cash flow management is needed eg good
management of working capital
Using debt can be interpreted as a signal of confidence in
the company’s cash flow
Confident that the management can pay off debt on a
regular basis

5. Practical capital structure considerations
Practical Issues Explanation
Life cycle A new growing business will find it difficult to forecast
cash flows with any certainty so high levels of gearing
are unwise
Operational gearing (Contribution / PBIT) If fixed costs are high, then contribution (I.e before
fixed costs) will be high relative to profits (after fixed
costs). High fixed costs mean future cash flows may be
volatile, so high gearing is not sensible
Stability of revenue If operating in a highly dynamic business environment,
then high gearing is not sensible
Security If a company is unable to offer security, then debt will
be difficult and expensive to obtain

6. Capital
Structure
Theories:
Traditional
Theory
The traditional theory of
capital structure says that a
firm's value increases to a
certain level of debt capital;
after which it tends to remain
constant and eventually begins
to decrease if there is too
much borrowing
A blend of equity and debt
financing can lead to a firm's
optimal capital structure.

10. Trade-Off Theory of Capital Structure
THE TRADE-OFF THEORY OF CAPITAL
STRUCTURE IS THE IDEA THAT A COMPANY
CHOOSES HOW MUCH DEBT FINANCE AND
HOW MUCH EQUITY FINANCE TO USE;
BY BALANCING THE COSTS AND BENEFITS AN IMPORTANT PURPOSE OF THE THEORY IS
TO EXPLAIN THE FACT THAT CORPORATIONS
USUALLY ARE FINANCED PARTLY WITH DEBT
AND PARTLY WITH EQUITY.

11. Finance for SMEs
Funding gap - inability
to raise sufficient
finance
Maturity gap – inability
to raise medium term
finance due to
inadequate collateral
Business angels,
supply-chain finance
and crowdfunding
Capital structure –
Inability to access
sufficient equity may
lead to high gearing