Capital Structure and Financial Offering

CAPITAL STRUCTURE AND FINANCIAL OFFERING: Return and Benefits to Investors, Financiers, and Business Partners

The following factors are considered at the time of designing the financial structure:  Leverage: Leverage can be both positive or negative. Nature of the company's financial position: Capital  Cost of Capital: The financial structure should and financial structures set the firm's level of focus on decreasing the cost of capital. Debt leverage. and preference share capital are cheaper sources of finance as compared to equity share Assets = Liabilities + Equities capital.  Control: The risk of loss and dilution of control of CAPITAL STRUCTURE the company should be low. - how investment (asset ownership) is financed.  Flexibility: Any firm cannot survive if it has a rigid - focuses on the balance between funding from financial composition. So the financial structure equities and funding from long term debt. Firms should be such that when the business use funds from both sources to acquire incomeenvironment changes structure should also be producing assets. adjusted to cope up with the expected or - also known as ‘Capitalization ‘ unexpected changes.  Solvency: The financial structure should be such Breaking down 'Capital Structure' that there should be no risk of getting insolvent. A firm's capital structure can be a mixture of long-term debt, short-term debt, common equity BREAKING DOWN 'Financial Structure' and preferred equity. A company's proportion of Like the capital structure, the financial short- and long-term debt is considered when structure is divided into the amount of the company's analyzing capital structure. When analysts refer to cash flow that goes to creditors and the amount that capital structure, they are most likely referring to a goes to shareholders. Each business has a different firm's debt-to-equity(D/E) ratio, which provides insight mixture depending on its needs and expenses. into how risky a company is. Usually, a company that Therefore, each company has its own particular is heavily financed by debt has a more aggressive debt-equity (D/E) ratio. capital structure and therefore poses greater risk to investors. This risk, however, may be the primary CAPITAL VS. FINANCIAL STRUCTURE source of the firm's growth. The following are the major differences between capital structure and financial structure: CAPITALIZATION STRACTURE 1. The capital composition of the company which - proportion of debt and equity in the capital includes only long-term funds raised is known as configuration of a company. capital Structure. The combination of long term - refers to the percentage of funds contributed to and short-term funds utilized by the company a firm's total capital employed by equity for acquiring resources is known as the financial shareholders, preferred shareholders and debtstructure. holders, in the form of common stock, preferred 2. Capital Structure appears under the head stock and debt. Shareholders Fund and Non-current liabilities. - significant bearing on measures of its profitability Conversely, the entire equity and liabilities side and financial strength, such as net profit margin, shows the financial structure of the company. return on equity, debt-equity ratio, and interest 3. Capital Structure is a section of Financial coverage. Structure. 4. Capital Structure includes equity capital, Breaking down 'Capitalization Structure' preference capital, retained earnings, While formulating or amending its debentures, long-term borrowings, etc. On the capitalization structure, a company must consider other hand, Financial Structure includes the pros and cons of various sources of capital. shareholder’s fund, current and non-current Although firms in the same business sector will liabilities of the company. generally have a similar capitalization structure, it 5. Capital structure is a subset of the financial varies widely across different sectors. structure that is more geared toward long-term analysis, while the financial structure provides FINANCIAL STRUCTURE more reliable information regarding the - mix of long term and short-term funds employed business's current circumstances. by the company to procure the assets which are required for day to day business. Trend Analysis DEBT VS. EQUITY and Ratio Analysis are the two tools used to  Debt is one of the two main ways companies can analyze the financial structure of the company. raise capital in the capital markets. Companies - represents the whole equity and liabilities side of like to issue debt because of the tax advantages. the Balance Sheet. Interest payments are tax-deductible. Debt also - it includes equity capital, preference capital, allows a company or business to retain ownership, retained earnings, debentures, short-term unlike equity. Additionally, in times of low interest borrowings, account payable, deposits rates, debt is abundant and easy to access. provisions, etc.  Equity is more expensive than debt, especially when interest rates are low. However, unlike debt,

equity does not need to be paid back if earnings R.E. until higher L / V ratio than for other types of decline. On the other hand, equity represents a investments (e.g., typical stock) claim on the future earnings of the company as a part owner. Debt and Inflation  "The more you borrow, the more money you make DEBT-TO-EQUITY RATIO AS A MEASURE OF CAPITAL just from inflation!" STRUUCTURE  Inflation is only the borrower’s friend ex post. - both debt and equity can be found on the  Ex ante (which is when it matters for leverage balance sheet. decision) the inflation argument is a fallacy. No - companies that use more debt than equity to positive NPV to borrower in loan transaction due finance assets have a high leverage ratio and an to inflation. However, fixed-rate debt leverage aggressive capital structure. makes equity position more of an "inflation - A company that pays for assets with more equity hedge". than debt has a low leverage ratio and a conservative capital structure. Project Level Capital Structure in Real Estate - a high leverage ratio and/or an aggressive Much real estate finance occurs at the microcapital structure can also lead to higher growth level of individual investments in properties, projects, rates. or “deals". Hence, much “capital structure” in real - a conservative capital structure can lead to lower estate occurs at this micro-level. growth rates.  Much real estate investment is still done directly - goal of company management to find the by individuals or small entrepreneurial firms. optimal mix of debt and equity, also referred to as  Also, real estate assets are relatively simple, the optimal capital structure. tangible and “transparent”. Makes them ideal candidates for secured debt and other types of DEBT AS AN INCENTIVE AND DISCIPLINARY TOOL FOR project-level financing (External investors need to MANAGEMENT feel confident that they know what is going on in  Leverage as a "disciplinary tool" to "incentivize". the investment even if they don’t have direct  Real estate physical assets are "easy to manage, management control or highly specialized not much risk or excitement or growth potential in expertise.) bricks & mortar" (e.g., compared to high-tech  Also, the law governing real property rights industries, world trade, etc). facilitates this type of finance.  With not much downside and not much upside, managers may tend to get "lazy", letting value- DIFFERENTIATED EQUITY PARTNERS (Classes) enhancing possibilities pass them by unnoticed.  Differentiate investors according to what they  With sufficient leverage, real estate becomes a bring into the deal and what they want to get out high-risk, high-growth investment, making it of it. sufficiently "exciting" to attract good managers,  Entrepreneurial investor may essentially bring giving managers sufficient incentive to max operational management ability and the deal value. itself.  Money partner brings most of the required equity DEBT AND LIQUIDITY cash but lacks the ability or desire to manage the  Leverage reduces the equity investor's "liquidity". operation of the project or property.  Liquidity is the ability to quickly obtain "full value"  Define different “classes” of partners or as cash. Underlying (physical) R.E. assets are stockholders in the ownership equity entity. illiquid. By not borrowing to the hilt, you can  Money partner has control over major capital obtain cash by mortgaging the prop. (i.e., if you decisions (financing and asset buy/sell decisions). don't borrow now, you can borrow later), thereby  Entrepreneurial partner may or may not reducing the illiquidity problem of real estate subordinate some of its equity claim to that of the investment. money partner (though the entrepreneurial partner may also take a fee for service). COST OF FINANCIAL DISTRESS - bankruptcy or foreclosure has large CONCLUSION "deadweight costs". Capital Structure and Financial Structure are  Agency Costs - high Leverage ratio conflict of not contradictory to each other. Instead, they are interest between equity owner vs debtholder. inseparable. The optimum capital structure is when Can cause prop. Owner to act sub optimally the company uses a mix of equity and debt financing (e.g.: avoid CI, pad expenses, high-stakes that the firm value is maximized and side by side the “repositioning” of rent roll, exercise mortgagor’s cost of capital is also minimized. “put”):  Moral Hazard - mere probability of these costs (deadweight, agency) reduces value of prop. if L / V too high.  Easy Management - low risk nature of R.E., & transparency (relatively easy for outsider to detect poor mgt, in part via ability to observe Prepared By: prop.val. in asset mkt) COFD does not “kick in” for Group 8 (STEM – G. Zara)