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capital structure

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Capital Structure decisions


Capital Structure is apart of finance, and is one of the key decisions that a financial manager of a company must make.  It refers to how the company will raise money in order to pay for their capital budgeting projects (how they will pay for the projects which they invest in).  Capital structure decisions revolve around proportions of debt and equity that a firm will use to finance its assets.  Whether it will use long term or short term debt, and in what percentage. This decision looks at the "right-hand side of the balance sheet"....ie debt and equity side. 


When looking at the financing of a company, it is common to think in terms of "dividing up the pie".  What is the best mixture of debt and equity that can maximize the value of the firm?  If you add more debt, we say that the company is adding more "financial leverage".  This means that the returns to shareholders will be magnified, but also that the firm is more risky to shareholders of equity.  This added risk is due to the fact that firms with added debt financing have additional fixed interest payments that they must make each month, so the fixed payments are higher.  The company is more risky because if they have a bad year, they might not be able to pay, and may be forced into liquidation.  On the other hand, debt financing is "cheaper" to the firm, and is therefore preferable.  It costs the firm less money to raise money by issuing debt than by issuing equity.  A third factor to also consider is that debt financing is tax preferable to equity financing because interest payments are tax deductible.  So, the government actually makes an incentive for companies to borrow and go into debt rather than to raise money in equity markets.  For these reasons, it is in companies best interest to pile up the debt, up to a point, because as the company goes more into debt, there is a point where too much debt raises red flags, and investors begin to see the company as too risky, and the cost of capital goes way up. 


The science of determining the optimal mix of debt and equity financing is what capital structure decisions are all about. 




Other managerial finance decisions to make:

1.  What long term investments should the company pursue? (capital budgeting decision)

2.  How can cash be raised for these investments? ( capital structure decision for a firm.

3.  How much short-term cash does the company need to pay its bills? (net working capital decision)



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