Capital structure

The balance between debt and ordinary share capital can have an significant influence over the wealth created for shareholders by the company in question. By altering the capital structure of a firm, wealth can be created. Capital structure refers to the level of debt in relation to ordinary share capital (Arnold 2008). Generally speaking it is cheaper to finance a company by using debt finance rather than raising equity finance. This is because lenders of debt finance typically expect lower returns to that of shareholders. Other advantages of using debt finance include the ability to offset any interest from borrowing against pre-tax profits, allowing the company to reduce their tax bill. Another advantage is avoiding the high costs associated with raising equity finance as mentioned in my previous blog concerning raising capital. The capital structure of a company is concerned with the level of gearing a company possesses. By this we mean the proportion of debt in the capital structure of a company (Arnold 2008). So if a there as so many clear advantages associated with using debt finance why do companies often want to reduce their level of gearing and avoid too much of their capital coming from debt? As with most things, there are disadvantages as well as advantages! One main disadvantage with using debt finance in comparison to equity finance is that if the company in question happens to find itself in a period of financial distress due to poor performance for example, they will still be obliged to pay back money borrowed from lenders at the agreed rate. This is all well and good if they are in a position to do so, however if they are heavily financed by debt this may prove to be a big concern. On the other hand, a company which has been financed heavily with equity finance will find itself in a position where it has no obligation to pay dividends to shareholders if they find that they are not in a position to do so and therefore can retain the money within the company, helping them during this time of uncertainty.

It seems that during the recent times of the global financial crisis, the importance of capital structure has become even more prevalent. Many companies have found themselves in a position of financial uncertainty, and restructuring their finances has become a clear focus to them to try and alleviate the problems that have arisen. A recent example of a company which has altered it's capital structure is that of EuroTunnel. The operator of the channel tunnel has found itself returning to profit this year and has decided to buy back some of it's debt to reduce interest repayments. By reducing it's level of gearing it is hoped that the company will have a more appropriate capital structure to cope better with any problems that may arise in future years. The company was able to do this due to record levels of passengers in 2011. In my opinion, the decision to alter the capital of the structure of the company following a successful year is a wise one as it will hopefully allow them to cope better in the future if passenger levels drop again for whatever reason.

As mentioned before, the effects of the global recession have been a strong incentive for many companies to re-consider the capital structure of the firm. Getting the balance right between debt and equity can ultimately decide the fate of the company. I think the move by EuroTunnel to alter the capital structure of the firm whilst in a position to do so was a very good one and shows a level of long-term vision being held by the directors. Despite not being obliged to pay shareholder dividends during rough times, surely the chance of keeping the company solvent should be of paramount importance to any set of directors, with the hope of dividends being available in future years when the company becomes more prosperous.