Long-term financing requires a meticulous understanding of the various features of debt and equity and their impact an organization. While evaluating debt and equity, an investment banker also has to consider the unique characteristics of the organization’s dealings while ensuring that the organization’s requirements are met.
Debt CapitalDebt capital includes all long-term borrowing incurred by the firm. The cost of debt was found to be less than the cost of other forms of financing. The relative inexpensiveness of debt capital is because the lenders take the least risk of any long-term contributors of capital. Their risk is less than that of other because (1) they have a higher priority of claim against any earnings or assets available for payment (2) they have a far stronger legal pressure against the company to make payment than do preferred or common stockholders, and (3) the tax-deductibility of interest payments lowers the debt cost to the firm substantially.
Equity CapitalEquity capital consists of the long-term funds provided by the firm’s owners, the stockholders. Unlike borrowed funds that must be repaid at a specified future date, equity capital is expected to remain in the firm for an indefinite period. The two basic sources of equity capital are (1) preferred stock and (2) common stock equity, which includes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and preferred stock, respectively (Pinegar, Wilbricht, 1989).
A firm’s capital structure is determined by the mix of long-term debt and equity it uses in financing its operations. Debt and equity capital differ with respect to voice in management, claims on income and assets, maturity, and tax treatment. Capital structure can be externally assessed using the debt ratio and the debt-equity ratio to measure the firm’s degree of indebtedness or the times interest earned ratio and the fixed-payment coverage ratio to measure its ability to meet fixed financial payments.
Research suggests is an optimal capital structure that balances the firms; benefits and cost of debt financing. The major benefit of debt financing is the tax-deductible interest, and the costs of debt financing include the probability of bankruptcy, agency costs imposed by lenders in their loan agreements, and asymmetric information costs attributable to managers having more information about the firm’s prospects than do investors (Modigliani and Miller, 1958).
Modigliani, Franco and Miller, Merton. (1958). The Cost of Capital, CorporationFinance, and the Theory of Investment. American Economic Review.
Pinegar, J. Michael and Wilbricht, Liza. (1989). What Managers Think of CapitalStructure Theory.
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