17.2: The Concept of Capital Structure

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Learning Objectives

By the end of this section, you will be able to:

Distinguish between the two major sources of capital appearing on a balance sheet.
Explain why there is a cost of capital.
Calculate the weights in a company’s capital structure.

The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These items the company needs to conduct its operations are assets. They appear on the left-hand side of the balance sheet.

The company has to pay for these assets. The sources of the money the company uses to pay for these assets appear on the right-hand side of the balance sheet. The company’s sources of financing represent its capital. There are two broad types of capital: debt (or borrowing) and equity (or ownership).

Figure 17.2 is a representation of a basic balance sheet. Remember that the two sides of the balance sheet must be $Assets = Liabilities + Equity$ . Companies typically finance their assets through equity (selling ownership shares to stockholders) and debt (borrowing money from lenders). The debt that a firm uses is often referred to as financial leverage. The relative proportions of debt and equity that a firm uses in financing its assets is referred to as its capital structure.

A basic balance sheet shows that the current and long term assets of a company are equal to its debt, preferred stock, and common equity. In this figure, debt, preferred stock, and common equity are represented by equal sized rectangles. These three rectangles stacked together are the same size as the rectangle representing current and long term assets. — Figure 17.2: Basic Balance Sheet for Company with Debt, Preferred Stock, and Common Equity in Capital Structure

Attracting Capital

When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock.

Suppose, for example, that you have $5,000, and you purchase Tesla stock. You could have purchased Apple stock or Disney stock instead. There were many other options, but once you chose Tesla stock, you no longer had the money available for the other options. You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments.

From Tesla’s perspective, this means that the company can only attract your capital if it offers an expected return high enough for you to choose it as the company that will use your money. Providing a return equal to what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets.

Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC).

The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure. If, for example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like Figure 17.3.

These weights can be derived from the right-hand side of a market-value-based balance sheet. Recall that accounting-based book values listed on traditional financial statements reflect historical costs. The market-value balance sheet is similar to the accounting balance sheet, but all values are current market values.

A balance sheet shows that the market value of assets are equal to market value of debt and the market value of equity. In this figure, the market value of debt is represented by a rectangle that is 25% of the size of the market value of assets. The market value of equity is represented by a rectangle that is 75% of the size of the market value of assets. These two rectangles are stacked on top of each other and together are the same size as the rectangle representing market value of assets. — Figure 17.3: Balance Sheet of Company with Capital Structure of 25% Debt and 75% Equity

Just as the accounting balance sheet must balance, the market-value balance sheet must balance:

Market Value of Assets = Market Value of Debt + Market Value of Equity

17.1

This equation reminds us that the values of a company’s debt and equity flow from the market value of the company’s assets.

Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million. Bluebonnet’s debt is trading at 97% of its face value. It has one million shares of stock, which are trading for $15 per share.

First, the market values of the company’s debt and equity must be determined. Bluebonnet’s debt is trading at a discount; its market value is $0.97 \times $ 5,000,000 = $ 4,850,000$ . The market value of Bluebonnet’s equity equals $Number of Shares \times Price per Share = 1,000,000 \times $ 15 = $ 15,000,000$ . Thus, the total market value of the company’s capital is $$ 4,850,000 + $ 15,000,000 = $ 19,850,000$ . The weight of debt in Bluebonnet’s capital structure is $\frac{$ 4, 850, 000}{$ 19, 850, 000} = 24.4%$ . The weight of equity in its capital structure is $\frac{$ 15, 000, 000}{$ 19, 850, 000} = 75.6%$ .