A large company's manufacturing facilities spread out across the globe. Capital could include employees working to create a profitable product or service economists generally refer to the latter as "human capital.
What really defines capital from a business and financial standpoint is its durability. Types of Capital While individuals can benefit from capital by investing in the financial markets or buying a home, and grow wealth over the long term, capital is largely a business wealth-driving component. In that sense, capital is simply a powerful tool to invest and grow a business.
Forms of Capital To break down the concept of financial capital for businesses more deeply, it's helpful to focus on the primary forms of capital, as follows: Debt Capital Debt can be a powerful capital appreciation tool, if used correctly. TheStreet Recommends. By Martin Baccardax. Corey Goldman. By Luc Olinga.
By Dan Weil. By Tony Owusu. By Jeanette Pavini. See More. Hybrid financing can come with fixed or floating returns, and can pay interest or dividends. Convertible Debt: A class of hybrid financing.
Convertible bonds are the most common type of hybrid financing, and usually take the form of a bonds that can be converted to equity. Convertible Equity: A class of hybrid financing. Convertible equity usually takes the form of convertible preferred shares, which is preferred equity that can be converted to common equity.
Preferred Equity: A class of financing representing ownership interest in a company. As opposed to fixed income assets e. However, preferred equity has both debt and equity characteristics in the form of fixed dividends debt and future earnings potential equity.
Correspondingly, it gives the holder upside and downside exposure. Generally, preferred equity obligates management to pay its holders a predetermined dividend before paying dividends to common shareholders.
On the flipside, preferred equity typically comes without voting rights. Common Equity: Also a class of financing representing ownership interest. The indirect costs arise because of change in investment policies of the firm encase the firm foresees possible financial distress. Static trade-off theory: this theory affirms that firms have optimal capital structures, which they determine by trading off the costs against the benefits of the use of debt and equity.
One of the disadvantages of debt is the cost of potential financial distress, especially when the firm relies on too much debt. Already, this leads to a trade-off between the tax benefit and the disadvantage of higher risk of financial distress. But there are more cost and benefits involved with the use of debt and equity. One other major cost factor consists of agency costs. Agency costs stem from conflicts of interest between the different stakeholders of the firm and because of ex post asymmetric information Jensen and Meckling and Jensen Hence, incorporating agency costs into the static trade-off theory means that a firm determines its capital structure by trading off the tax advantage of debt against the costs of financial distress of too much debt and the agency costs of debt against the agency cost of equity.
Many other cost factors have been suggested under the trade-off theory, and it would lead to far to discuss them all. Therefore, this discussion ends with the assertion that an important prediction of the static trade-off theory is that firms target their capital structures, i. On the basis of determinants of capital structure in static trade-off theory are Non-debt tax shield and Business Risk having negative, Profitability, Firm size, and Asset tangibility having positive effect on the debt-to-capitalratio Dynamic Trade-off Theory: This Constructing models that recognize the role of time requires specifying a number of aspects that are typically ignored in a single-period model.
Of particular importance are the roles of expectations and adjustment costs. In a dynamic model, the correct financing decision typically depends on the financing margin that the firm anticipates in the next period. Some firms expect to pay out funds in the next period, while others expect to raise funds. If funds are to be raised, they may take the form of debt or equity. More generally, a firm undertakes a combination of these actions. An important precursor to modern dynamic trade-off theories was Stiglitz , who examines the effects of taxation from a public finance perspective.
Stiglitz's model is not a trade-off theory since he took the drastic step of assuming away uncertainty. The first dynamic models to consider the tax savings versus bankruptcy cost trade-off, Brennan and Schwartz They Analyzed continuous time models with uncertainty, taxes, and bankruptcy costs, but no transaction costs.
Dynamic trade-off models can also be used to consider the option values embedded in deferring leverage decisions to the next period.
Goldstein et al. Under their assumptions, the option to increase leverage in the future serves to reduce the otherwise optimal level of leverage today. Again, if firms optimally finance only periodically because of transaction costs, then the debt ratios of most firms will deviate from the optimum most of the time. In the model, the firm's leverage responds less to short-run equity fluctuations and more to long-run value changes. Much of the work on dynamic trade-off models is fairly recent and so any judgments on their results must be somewhat tentative.
Agency Theory Berle and Means initially developed the agency theory and they argued that there is an increase in the gap between ownership and control largeorganisations arising from a decrease in equity ownership.
Furthermore, acting as agents to shareholders, managers try to appropriate wealth away from bondholders to shareholders by taking more debt and investing in risky projects. To be more specific, the following summary points are presented. Managers having less than percent stake in business may try to use the free cash flows sub- optimally or use them to their own advantage rather than to increase value of the firm.
Here the reduction in cash flow because of debt financing is considered to be the benefit of debt financing. If investment yields high returns, the extra or additional benefits go to shareholders and if the firm fails, the bondholders International Research Journal of Commerce Arts and Science http:www.
So bondholders share extra risks for no reward. Being agents to shareholders, management tries to invest even in projects that may not have good chances of viability. On the other hand, the underinvestment problem refers to the tendency of managers to avoid safe net present value projects in which value of equity may decrease a little, however, increase in value of debt maybe high.
This happens because management, being primarily responsible to shareholders, does not concern itself with the overall increase in value of the firm rather it tries to increase the value of equity only Myers and Majluf Jenson and Meckling propose that optimal capital structure is reached by trading off the agency costs of debt against the benefits of debt.
This particular situation provides a platform for managers to pursue their own interest instead of maximizing returns to the shareholders. In other words, the duty of top managers is to manage the company in such a way that returns to shareholders are maximized thereby increasing the profit figures and cash flows Elliot, However, Jensen and Meckling explained that managers do not always run the firm to maximise returns to the shareholders. Their agency theory was developed from this explanation and the principal-agent problem was taken into consideration as a key factor to determine the performance of the firm.
Jensen and Meckling , p. The problem is that the interest of managers and shareholders is not always the same and in this case, the manager who is responsible of running the firm tend to achieve his personal goals rather than maximising returns to the shareholders.
This means that managers will use the excess free cash flow available to fulfil his personal interests instead of increasing returns to the shareholders Jensen and Ruback, Hence, the main problem that shareholders face is to make sure that managers do not use up the free cash flow by investing in unprofitable or negative net present value NPV projects. Instead these cash flows should be returned to the shareholders, for example though dividend payouts Jensen, The costs of monitoring the managers so that they act in the interests of the shareholders International Research Journal of Commerce Arts and Science http:www.
Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity. Assuming that a company has access to capital e. This can be done using a weighted average cost of capital WACC calculation. To calculate WACC the manager or analyst will multiply the cost of each capital component by its proportional weight.
A company with too much debt can be seen as a credit risk. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital as equity tends to be more costly than debt. Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure.
What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment. In addition to the weighted average cost of capital WACC , several metrics can be used to estimate the suitability of a company's capital structure. Financial Ratios. Company Profiles. Tools for Fundamental Analysis.
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