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You often hear corporate officers, professional investors, and investment analysts discuss a company’s capital structure. You may not know what is a capital structure is or why you want to talk about something that sounds but technical but rest assured that the concept is extremely important because it is not only a return company but its shareholders for earnings or not firm survives in a recession or depression Sit back, relax, and prepare for a basic introductory course on capital structure and why it matters to your investment portfolio!
Capital Structure – What is It Is and Why It Matters
The term capital structure refers to the percentage of capital (money) on a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each type of capital has its benefits and drawbacks, and a substantial portion of wise corporate stewardship and management is trying to find the perfect capital structure. This is true for Fortune 500 companies and for small business owners trying to determine how much their start-up money should be.
Let’s take a moment to look at these two forms of capital
Equity capital refers to the shareholders (owners). Typically, equity capital comprises two types:
Contributed capital, which is the money that was originally invested in the business in exchange for shares or ownership.
Retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund development, acquisitions, or expansion.
Many consider the equity capital to be the most expensive type of capital a company can use because its “cost” is the return to the firm. A speculative mining company that looks for silver in a remote region of Africa may require a much higher return on equity to get investors to buy from a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.
The debt capital in a company’s capital structure refers to borrowed money that is at work in the business. The safest type is commonly considered long-term bonds, because the company has years, if not decades, to come up with the principal.
Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General Electric that are the day-to-day working capital requirements such as 24-hour loans to the capital markets. payroll and utility bills The cost of debt capital in the capital structure depends on the health of the company’s balance sheet – a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with a lot of debt, which can pay up to 15 percent or more in exchange for debt capital
Aside from equity and debt capital, there are other forms of capital, such as vendor financing where a company can sell goods before they have been paid to the seller, that can drastically increase return on equity but company’s cost is nothing. This was one of the secrets to Sam Walton’s success at Wal-Mart. He was able to sell Tide Detergent before being able to pay the bill to Procter & Gamble, in effect, using PG’s money to grow his retailer.
In the case of an insurance company, the policyholder “float” represents the money that does not belong to the firm but that is it to use and earn an investment on it is for accident or medical bills, in the case of an auto insurer The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.
Seeking the Optimal Capital Structure
Many middle-class investors believe that the goal in life is to be debt-free. When you reach the upper echelons of finance, however, that idea is less straightforward. Many of the most successful companies in the world base their capital structure on one simple consideration – the cost of capital.
If you can borrow money at 7 percent for 30 years in a world of 3 percent inflation and reinvest it in core operations at 15 percent, you will be wise to consider your total capital structure at least 40 percent to 50 percent in debt capital. If your sales and cost structure are relatively stable
If you sell an indispensable product that people simply have to, the debt will be a much less risk than if you are a tourist park at a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom comes in play
The great managers have a knack for consistently lowering their Increasing productivity, the average cost of capital, demand for higher return products and more. This is the reason that you often see that very profitable customer stamp companies take advantage of long-term debt by issuing corporate bonds.
To really understand the concept of capital structure, you will have to take some time to read about the DuPont model, how the capital structure represents one of the three components to determine the company’s return rate. In one of the three components. Owners have invested in it. Whether you are a donut shop owner or are looking to invest in publicly traded stocks, if you want to develop a better understanding of risks and returns, then this should be the knowledge.
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