Factors affecting capital structure and the cost of capital

How much financing does a company need?

A company’s capital structure is its mix of debt and equity. The amount of financing it needs depends first on its business model.

Capital structurethe mix of debt and equity

• Business model Memorize sets how much financing
  • Capital-intensive many assets; secured debt and leases
  • Capital-light few assets; little outside funding
• Life-cycle stage Memorize sets what kind
  • Start-up equity, plus leases and convertibles
  • Growth equity still leads; secured debt
  • Mature unsecured debt; payouts
• Regulation Know the idea may force more equity

Capital-intensive businesses need a great many assets: utilities, transport, real estate, chip fabrication and resource extraction. The signs are low asset turnover (sales relative to total assets), high capital expenditure relative to sales, and high working capital relative to sales. They need a lot of financing, and because their assets can be pledged, much of it is cheap: secured debt is backed by specific assets as collateral, and leases give the company the use of an asset in return for lease payments, much like a loan. Both usually cost less than unsecured borrowing because the asset protects the lender. This works best for liquid, widely useful assets such as offices, aircraft and vehicles, and poorly for a specialized factory in a remote location.

Capital-light businesses hold few physical assets and so need little outside funding. Typical reasons: they run a network that others’ assets plug into (a booking platform earning fees), they are paid upfront or have a very short or negative cash cycle, they pay staff partly in shares, or they are profitable early and have no need to expand fast. Many businesses have become lighter by separating the heavy assets from the brand: a franchisor leaves the buildings to owners, and a chip designer leaves fabrication to a foundry.

Regulation can also shape the mix. Banks must hold minimum equity against their assets, and regulators of utilities influence capital structure through rate setting. This usually forces more equity than the company would otherwise choose, which raises WACC.

What kind of financing fits each stage of a company’s life?

The corporate life cycle runs from start-up through growth to maturity, and a company’s capital structure changes as it moves along. The table shows how business risk and cash flow decide what lenders will offer.

	Start-up	Growth	Mature
Revenue growth	initial	rising	slowing
Free cash flow	negative	improving, often still negative	positive, stable
Business risk	high	medium	low
Debt availability	little or none	rising	high
Typical debt	leases, convertible debt	secured	unsecured
Main equity source	founders, employees, venture capital	equity still dominant	buybacks and dividends possible

A start-up has little or no revenue, negative free cash flow and a high chance of failure, so lenders stay away. Exchanges also set size and profit requirements, so the equity comes from founders, employees and venture capital rather than a public offering. The only debt on offer is usually leases and convertible debt , which lets the lender convert into shares at a preset price and often defers interest until maturity.

A growth company still spends heavily on marketing, capacity and working capital, so free cash flow is often negative even if the business is profitable. Improving visibility attracts lenders, who want collateral. Many growth firms borrow conservatively to avoid distress, and equity remains the main source.

A mature company has slow, predictable growth and reliable positive free cash flow. It can borrow unsecured, which is cheaper than equity, and many large mature firms use a lot of debt while trying to hold an investment-grade rating. They may return capital through higher dividends or buybacks. A start-up or growth company can sit inside a mature industry (a new restaurant concept, for instance), so the stage belongs to the company, not the industry.

What determines the cost of debt and equity?

Investors set the costs of debt and equity in markets. Both respond to the same risks because they are claims on the same cash flows, so they tend to move together, with equity always above debt.

Cost of capitalset by investors in markets

• Top-down factors Use it affect many issuers at once
  • Market conditions interest rates, credit spreads, equity prices
  • Industry exposure oil helps producers, hurts airlines
• Issuer-specific factors Memorize investors reprice each one
  • Sales risk stable, recurring revenue is cheaper
  • Operating leverage fixed ÷ total costs
  • Financial leverage and coverage EBIT ÷ interest
  • Collateral liquid assets support cheaper debt

Top-down factors. Economic conditions move everyone’s required returns: growth, inflation, monetary policy and exchange rates affect government yields and credit spreads. Spreads widen when recession risk rises, most sharply for cyclical sectors such as mining, materials and industrials, whose revenue swings with the economy. Companies prefer to borrow when rates and spreads are low and to issue equity when share prices are high. Industry matters too: a higher oil price helps the credit of oil producers and hurts airlines.

Issuer-specific factors. Investors adjust the market-wide rates for four things.

1. Sales risk. Stable, recurring, diversified revenue (a subscription software firm, a telecom operator) earns cheaper financing than volatile revenue (vehicle or construction-equipment makers).
2. Operating leverage. The share of fixed costs, covered next.
3. Financial leverage and interest coverage. How much debt the company already carries.
4. Collateral. Strong, liquid, widely useful assets support more and cheaper debt.

What is operating leverage?

Operating leverage measures how much of a company’s cost base is fixed. A high share of fixed costs means that when sales fall, costs do not, so profit falls much faster than sales.

$$\text{Operating leverage} = \frac{\text{Fixed costs}}{\text{Total costs}}$$

What are financial leverage and interest coverage?

Financial leverage is the use of debt, often measured as debt (or debt net of cash) relative to a profit measure or to equity. A company that already owes a lot has committed its cash flow to interest and principal, so it can add less debt and its equity sits behind big priority claims. Both lenders and shareholders ask for more.

Interest coverage shows how comfortably core profit covers the interest bill.

$$\text{Interest coverage} = \frac{\text{EBIT}}{\text{Interest expense}}$$

Go deeper Same assets, two ways to finance them

Two firms each have assets of 250 and face the same EBIT outcomes. Ignore taxes. Firm P has debt of 50 (interest 3) and equity of 200. Firm Q has debt of 150 (interest 10) and equity of 100.

EBIT	P coverage	P return on equity	Q coverage	Q return on equity
40 (down 20%)	13.3×	18.5%	4.0×	30.0%
50 (base)	16.7×	23.5%	5.0×	40.0%
60 (up 20%)	20.0×	28.5%	6.0×	50.0%

Q’s equity earns far more in good years, but its range of outcomes is much wider and its coverage is thinner. P can lose most of its EBIT and still pay interest. Investors will require lower returns on both the debt and the equity of P, all else equal. Q’s return on equity at the base case is (50 − 10) ÷ 100 = 40%.

Return on equity for Q

TI BA II Plus HP 12C

1. 50−10=÷100= 0.4

1. 50ENTER10−100÷ 0.4

ENTER enter (on the HP, puts the number on the stack)

Go deeper Timing the market and moving assets to partners

Issuers tend to borrow when rates and spreads are low and to sell shares when prices are high, which is one reason actual capital structures drift. Some companies move capital-heavy assets to partners (franchise and foundry models) to become capital-light, trading ownership for contracts and fees.

Exam tip Fixed costs are the risk: high operating leverage, thin coverage and weak collateral all push the cost of capital up.