Okay so remember that the proportions of debt and equity a firm has outstanding can be referred to as its capital structure. Today we are going to delve a little deeper in the some of the advantage and disadvantage of different capital choices for firms.
One advantage of using some debt in the capital structure of a firm is that it enables them to leverage the equity for an increased investment. In layman's terms this means that it lets them spend more money than the firm has access. Another advantage of firms using debt is the tax benefit derived from the interest payments. Firms are able to deduct interest expenses from their taxable revenues to create a more favourable tax environment.
However, despite the advantages using too much debt has the potential to put the firm in serious financial distress. If a firm who has used excess debt in their capital financing has difficulty meeting its debt obligation (repayments), they may eventually be forced in bankruptcy. Even if the financial difficulty does not spread to the extent that it forces bankruptcy it can still have negative consequences. These may include: loss of customers, loss of suppliers, cost to employees, and fire sales of assets (selling assets very quickly accepting prices that are well below market value).
So now we know some of the main advantages and disadvantages we reach THE question regarding capital financing and capital structures.
'What is the optimal capital
structure?'
Or in other words - 'How much debt is too much?’. This question is very difficult to answer in generic terms as it will vary for each firm. In finance there are ratios and calculations that are used to try and estimate the answer to this question. However, in reality the answer is at the point where the probably and magnitude of the firm incurring financial distress outweighs the advantages of including debt in the capital structure.
I'm sorry to end on that ambiguous answer but the answer will be individual for each company. If you would like to know more about the calculations and ratios make sure you email illuminatingfinance@gmail.com (or if you have any other questions!)
