Capital Structure
The term capital structure denotes to the percentage of capital or money at work in a business by type. In broadly manner, there are two forms of capital:
I) Equity capital
II) Debt capital.
each one has its own does good and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the capital structure in terms of risk or reward pay off for shareholders. This is accurately placed for Fortune 500 companies and for small business proprietors attempting to ascertain how much of their start up money should come from a bank loan without pose a threat to their business.
Their detail description is as following:
I) Equity Capital:
Equity Capital refers to money put up and owned by the shareholders. In typical manner, equity capital lies in of two types:
a) Contributed capital:
It is the money that was originally invested in the business in exchange for shares of stock or ownership
b) Retained earnings:
It represents profits from past years that have been kept by the company and utilized to strengthen the balance sheet or fund growth, acquisitions, or expansion.
Many people believe equity capital to be the most expensive type of capital a company can utilize since its cost is the return the company must bring into attract investment. A speculative mining company that is looking for silver in a distant region of Africa may require a much higher return on equity to get investors to purchase the stock than a company such as Procter & Gamble, which sells everything from shampoo, beauty products and toothpaste and to detergent and
II) Debt Capital:
The debt capital in a company's capital structure cites to borrowed money that is at work in the business. It is the most dependable type is in general, looking at long-term bonds since the company has years, if not a period of 10 years, to come up with the principal, while paying interest only in the mean time.
Other types of debt capital can let in short-term commercial paper utilized by giants such as Walt Mart and General Electric that amount to billions of dollars in 24 hour loans from the capital markets to meet day to day working capital needs such as utility bills and payroll. The cost of debt capital in the capital structure be contingent upon on the health of the balance sheet of the company's such that a triple AAA rated company is going to be able to borrow at extremely low rates versus a questioning company with tons of debt, which may have to pay 15% or more in exchange for debt capital.
Other Forms of Capital:
There are in reality other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can an increase in a in a drastic manner, return on equity but don't cost the company anything. This was one of the mystery to Sam Walton's achievement at Wal-Mart. He to a great deal, was able to sell Tide detergent before bearing to pay the bill to Procter & Gamble. In effect, using Procter & Gamble's money to develop his retailer. In the case of an insurance company, the policyholder float comprises money that does not belong to the company but that it gets to employ and bring in an investment on until it has to compensate it out for accidents or medical bills in the case of an auto insurer. The cost of other class of capital in the capital structure alters greatly on a case by case basis and to a great deal comes down to the natural ability and discipline of managers.
Attempting the Optimal Capital Structure
Many middle class investors believe that the aim in life is to be debt-free. Many of the most successful companies in the world base their capital structure on one simple consideration that the cost of capital. If investor can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%,investor would be overbold to consider at least 40% to 50% in debt capital in investor overall capital structure.
As might be expected, how much debt investor take on comes down to how secure the revenues investor business brings forth. If investor sell an essential product that people simply must have, the debt will be much lower risk than if investor operate on a theme park in a tourist town at the pinnacle of a boom market. Another time, this is where managerial talent, experience, and wisdom comes in to existence. The great managers have a hang for consistently lowering their weighted average cost of capital by increasing productivity, attempting out higher return products and more.
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