Capital Structure and Its Impact on Valuation

 INTRODUCTION

Capital structure is a means through which a firm can finance its operating and growth activities by combining debt and equity. It affects the risk level, profitability level, and general financial health. Companies seek that special balance, referred to as the optimal capital structure. This article shall try to explain the definition of capital structure, the types of capital, and what’s its importance, along with examples and explanations of practical situations to provide a clear view of the very crucial financial concept.
Capital structure is defined as the specific combination of debt and equity a firm uses to support its wide-ranging operations and future development. A business that strikes an optimal capital structure can fund all its activities with maximum flexibility in finance. Ideally, equity capital represents the investment of the shareholders, and, on the other hand, debt capital is borrowed money that is often in the form of loans or bonds.

The primary purpose of capital structure is to determine how to allocate the funds to do optimum utilization of funds and how much to borrow and how much a share a company is ready to dilute. There are basically four types of capital structure with a mix of both equity and debt:

1. Horizontal Capital Structure: In this type of capital structure, there are zero debt components in the structure mix, which means it only contains equity capital. The structure is quite stable. Expansion of the firm takes place in a lateral manner, i.e., through equity or retained earnings only. The absence of debt results in a lack of financial leverage. The probability of disturbing the structure is remote.
2. Vertical Capital Structure: In this type of capital structure, there is a small amount of equity capital at the base of the structure, and the other part is debt. It also forms the basis upon which the superstructure of preference share capital and debt is erected. The incremental addition to the capital structure is almost entirely in the form of debt. The quantity of retained earnings is low, and the dividend pay-out ratio is quite high. Such a structure generally always has a cost of equity capital that is more expensive than the cost of debt. The high component of debt makes the capital structure of the firm vulnerable to a great deal of financial risk, hence making the structure unstable. The firm, due to the relatively smaller component of equity capital, is vulnerable to hostile takeovers.
3. Pyramid shaped Capital structure: Equally notable is the fact that a pyramid-shaped capital structure is heavily dominated by equity capital and retained earnings, which had been ploughed back into the firm over a considerably large period of time. The cost of share capital and the retained earnings of the firm is usually lower than the cost of debt. This structure indicates risk for the conservative firms.
4. Inverted Pyramid-shaped Capital Structure: Such a capital structure has a small component of equity capital, a reasonable level of retained earnings, but an ever-increasing component of debt. All the increases in the capital structure in recent years have been made through debt only. This type of capital structure is highly vulnerable to collapse. 

Why Is It Important to Have Optimal Capital Structure?

By the term optimal capital structure, we mean a particular arrangement of various components of the structure that is just in line with both the long-term and short-term objectives of the firm. An optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its optimal capital structure, which is that capital structure with which there is a balance between the ideal debt-to-equity range and minimizes the cost of capital of the firm. Any less or more combination than the optimal combination would be less than satisfactory. Hence, suboptimal combination would affect the achievement of the objective of maximization of the wealth of the shareholders. For designing such a structure, one will need the following information:

• What are the requirements of capital of the firm? • Is there the availability of different components? • What is the cost of these components? 
• Rate of return from investment

HOW CAPITAL STRUCTURE EFFECTS VALUATION OF THE FIRM:

It is important that the capital structure be conducive to an increase in the valuation of the firm. By valuation, we mean that the market value or the realizable value of the owners’ equity should increase. This can happen in cases where the value of both components of the shareholders’ equity, that is, share capital and retained earnings, increases. This can be reflected in the market value of the firm if the shares are traded on the stock exchange. The market value under ideal conditions is the indicative value of the inherent value and is therefore different from both the face value and book value. The capital structure should be such that it maximizes the inherent value of the firm. Retained earnings have a book value that is the value at which these earnings will be carried in the books of the firm. The inherent value of the retained earnings depends upon the future returns that these earnings can generate for the owners. Valuation of the firm increases with earnings of the firm. The rise in earnings is direct as well as indirect. This increase could be either through an increased level of operations of the firm or the fall in the firm’s cost of capital. The increase in earnings would depend directly on the investment decisions of the firm; however, changes in capital structure would have no explicit bearing upon those earnings. Capital structure forms an important part of the increase in earnings brought about by the change in cost of various constituents of the capital structure.

1. Debt vs. equity in capital structure: 
   Debt: That money borrowed by a company and repayable usually with some rate of interest. It could be in the form of bonds, loans, etc.
   Equity: Represents ownership interest in the company, usually in the form of a share of stocks. Equities are the residual claimants, so they have priority over debt after liquidation. When the company’s valuation is done, this aspect plays a vital role, as if more debt is there, the company valuation is expected to fall. 
2. Cost of Capital:
   Weighted Average Cost of Capital (WACC): WACC refers to the cost incurred by a firm for getting capital as an average of the cost of debt and equity. It matters because when investors use income-based valuation, such as discounted cash flow, they convert the project cash flow to the present value discount rate.
3. Leverage and Its Effect on Valuation: It means the use of debt to finance the company’s operations. Leverage can increase returns to equity holders when a company is performing well, while losses can also occur during downturns. Increased leverage will lower the cost of capital due to the tax shield; in turn, it will increase the company’s value; excess leverage that is beyond a certain point will lead to financial distress and bankruptcy risk, which will lead to a higher cost of capital and a lower company’s valuation.   

CONCLUSION-:

The capital structure of a company plays a vital role in valuation by influencing different factors such as cost of capital, risk profile, and financial flexibility. So, it is important for a company to have an optimal mix of both debt and equity, which can lower the cost of capital, increase the company’s value, and maximize shareholder returns. When there is too much debt, it will lead to a risk of financial distress, while more equity will lead to underutilization of tax advantages.

Therefore, understanding the balance between debt and equity is very crucial for investment bankers when they are advising companies on decisions like financing decisions, mergers, and acquisitions.