Methodology

Stocks

Module 6

What is unsystematic risk?

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Capital structure

Capital structure

Capital structure refers to the amount of debt that a company has in comparison to its levels of equity (money raised through selling shares, represented by market capitalisation). Striking the right balance between the two types of financing is crucial for the financial health of a firm.

 

If a company has too much debt, then it may not be able to keep up with interest payments. This is obviously a problem that could threaten the future of the business, not only in terms of future growth but also in terms of existence. Meanwhile, if a company takes on too much equity finance, then the company will lose ownership of itself, which would mean that it would have to consider the voices of shareholders when making certain decisions.

 

Having a lot of shareholders is not necessarily a good choice for a company as it leads to increased administration costs, less control and more pressure to hit certain targets. In addition to that, it also makes it more expensive (or even impossible) for a company to buy back their own shares.

 

Capital structures vary, so investors should make comparisons between companies within the same industry to see what is normal or not.

Trade-off theory

Trade-off theory states that the management of a company should only raise capital if the benefits outweigh the drawbacks. So, if a firm can achieve significant growth by altering its capital structure, then it is worthwhile.  For example, a company may consider increasing their levels of debt to use the money to fund a new project. As long as the project is successful, then it is worthwhile. If the project is not successful, then the drawback of paying a high-interest rate would outweigh the benefit.

 

From the viewpoint of an investor, knowing whether a project will be successful or not is a challenge. The best way to determine this is by looking at the track record of the company, to see how it has performed when introducing new projects. If a company has a long history of successful projects, then it should give the investor confidence that any new debt or equity finance will be used effectively.

 

In addition to that, ensuring that a company is raising finance to invest in a project that they already have experience in is important. If a company plans to raise finance to move into a new field, it is much more likely that they will fail.

 

As always, getting to know the companies that you invest in is key. All relevant information can be found in the annual reports of each company.

Pecking order theory

Pecking order theory states that each type of financing can be ranked into a order of risk. It outlines that equity finance (money raised through selling shares) is the riskiest option, with debt financing being less risky. This is the case because it claims that the amount of money that a company would spend repaying debt, is a lot less than the company will pay to try to buy back the stocks that they have sold. Companies typically have the goal of trying to buy their own stock back, in order to retain full control of themselves.

 

Of course, when a company lists on the stock market for the first time, the trade-off of raising equity finance outweighs the drawbacks, as they are able to raise huge amounts of money and are usually in the growth phase. 

 

Debt is also preferable as it is tax-deductible, which means that the company is able to reduce how much tax they pay on their earnings.

 

Finally, pecking order theory suggests that the best financing option is for a company to use their own cash. This is because they won’t have to pay interest payments over the long term or won’t need to lose any control. With that in mind, from an investors perspective, it would be better to see a company using their own cash when they can, rather than always taking on debt or selling shares.

What does capital structure refer to?

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