A company capital structure regards the way a firm finances its assets. A firm can finance its businesses either by equity or debt, as well as a different combination of the two sources. A company capital structure can contain a lot of debt aspect or a lot of equity aspect, one of the two elements or an equal measure of both equity and debt. Each technique of financing a business has its own advantages and disadvantages; therefore, the business should do an evaluation and choose the best form of financing the business. Moreover, there are a number of capital structure theories attempting to relate the company’s leverage with the company’s market value. This papers aims at evaluating capital structure debate, issues, and theory, while demonstrating how choices of capital structure influence the risk profile and return on investment (ROI) of a selected publicly-held company.
Capital Structure Analysis
Capital structure refers to the manner in which business is financed. A firm can consider financing its business using debts, equity or a mixture of debt and equity at different ratios. The best way to finance a business is determined by the company’s leverage ratio. This is basically determined by the debt to equity ratio. Low debt cost increases return on equity relative to return on asset. However, debt can be very expensive that it lowers the return on equity below return on capital. This puts a business into higher risk, a situation that should be highly avoided. Capital structure affects credit risk. Credit risk is the likelihood that an entity will not manage to pay debts obligations at the right time. A company with low probability of default, low fixed commitments cost and small debt amount is considered to have minimal credit risk. The company capital structure risk can also be measured by use of leverage index. This is computed as ROE/ROA. A ratio of more than one demonstrates a favorable debt financing utilization (Welch, 2011).
Business and Financial Risks Related to Capital Structure
The financial and business risk of a company highly depends on the adopted capital structure. According to Welch (2011), the employment of non-equity capital that include leasing, borrowing or any other contractual agreement develops a set financial commitment to a firm in form of rent, interest or other duties. This non-equity capital commitment to supplier, yield to financial risk. As leverage augment, the financial commitment rises and thus, the risk rises too. Actually according to Welch, an equal ration loss or gain on assets (ROA) results to a higher magnitude of equity capital (ROE) loss as compared to the gain. This defines the increasing risk principle. Similarly, if the return on invested capital (ROA) is higher than cost of employing non-equity capital there is leverage use gain in increased returns form to the business owner.
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