Capital Structure

Capital structure describes how a company's financing is composed of equity and debt. It shows the relationship between the owners' money and borrowed funds. The mix influences both risk and potential return.

Debt is normally cheaper than equity, because it ranks ahead, is often secured and its interest may be tax deductible under the applicable rules, which produces the tax shield of leverage. As leverage rises, however, so does the probability of financial distress, so both lenders and shareholders demand higher returns. From this trade-off between tax benefit and insolvency costs theory derives a target capital structure, while in practice sector norms, cash flow stability and lender requirements set the limits. Restrictions on interest deductibility may limit this benefit. Financing decisions therefore depend on the tax saving actually expected, rather than an assumed benefit from every additional euro of debt.

Modern structures are seen not as a simple split but as a sequence of ranks from senior bank debt, unitranche facilities, mezzanine, vendor loans and equity, supplemented by instruments such as preferred shares with their own ranking. In valuation the target capital structure feeds into the weighted average cost of capital and also determines the factor at which beta is relevered. In leveraged buyouts capital structure is an important starting point for the transaction, because sustainable debt together with available equity limits the affordable purchase price.

It should also be borne in mind that the optimal structure depends not only on arithmetic but on the volatility of the business: a cyclical company with a high fixed cost base tolerates considerably less debt than one with contractually secured recurring revenue, even where both report the same EBITDA. The maturity profile has a similar effect, since high leverage with long tenors is more manageable than moderate leverage requiring near-term refinancing. Both therefore belong alongside the pure leverage ratio.

Note: This explanation is for general information only and does not constitute tax advice. Tax treatment depends on the individual case and may change with new legislation. For a binding assessment, please consult a qualified tax adviser.