Capital structure, the mix of various sources of funding used by a company to finance its operations and investments, plays an essential role in corporate finance decisions. A well-planned capital structure allows companies to balance debt and equity, managing risks and taking advantage of opportunities. This structure is one of the critical factors considered by companies when making financing decisions.
Financing decisions, on the other hand, refer to the choices a company makes regarding how to raise funds. Such decisions come in different forms and shape, depending on the needs, goals, and situation of the company. They include debt financing, equity financing, hybrid financing or internal financing. The primary concern of financing decisions is to find a cost-effective solution that will give the company the needed capital without compromising its financial well-being.
But, how do capital structure and financing decisions relate?
The capital structure of a company determines how much equity it must raise to finance its capital investments. In turn, the financing decision of a firm will govern how the capital structure is configured. A company that raises significant amounts of equity will have a more stable financial structure than a firm that raises a lot of debt financing. On the other hand, companies using more debt financing will have a higher degree of leverage that can amplify both the effects of positive and negative events on their finances.
One of the critical considerations of capital structure and financing decisions is the cost of capital. The cost of capital refers to the total cost of raising capital, including both the capital’s cost and the cost of managing and repaying debt. Both debt and equity financing come with different costs and risks that will affect a company’s decision.
For instance, debt financing may come in the form of bank loans, bonds, etc., with set interest rates and periodic repayment schedules. These predefined payments help a firm to manage the cost of financing, allowing them to manage the company’s financial well-being to better control negative events on their finances. However, a more substantial amount of debt could expose a company to a higher risk and lower credit ratings that can sour the company’s future financing choices.
On the other hand, equity financing comes from the sale of company shares through an Initial Public Offering (IPO) or a private placement. Equity financing has no fixed repayment schedule, making it harder to manage the cost of financing. Still, it is less risky and less expensive than debt financing. As a result, companies choose equity financing to raise large sums of money for long-term investments in their firm’s future.
Capital structure and financing decisions are two essential facets of corporate finance that interconnect to create the best possible structure for a firm’s financial well-being. A well-crafted capital structure allows companies to balance the advantages and disadvantages of various financing options, while financing decisions enable companies to decide which financing mix they should use. By carefully considering capital structure and financing decisions, companies can effectively manage their finances and ensure their long-term growth and success.