Introduction
In this lecture we analyze the firm’s capital structure and its impact on the value and returns of a company. Capital structure is defined as the composition of all the securities the firm issues in order to finance its operations. These securities can be different in many respects:
· Leverage: the amount of debt financing relative to equity financing
· Maturity: we can have long-term and short-term debt.
· Fixed versus variable payments: some bonds and loan agreements have interest rates fixed
until maturity, whereas others are reset in certain intervals of time.
· Seniority: We can have different priorities associated with debt, where senior creditors have always to be paid before junior creditors.
· Currency: Bonds and bank loans can be denominated in different currencies, and some firms have even issued hybrid "dual currency" bonds that have interest payments in one and
principal payments denominated in another currency.
· Control: Securities confer control rights to the owner, e.g., owners of common stock can vote at annual general meetings, whereas creditors often have the right to stop the firm from paying dividends or selling assets that serve as collateral.
· Contingencies: Some securities have repayments that are contingent on future events. Convertible bonds are bonds that can be converted into stock at the discretion of the
bondholder, trading an entitlement to future coupons and principal payments into an
entitlement to future dividend payments and capital gains.
This list is not complete, and in this note we will only attempt a first approach on this problem.
Many of the considerations regarding the choice between these classes of securities are firm specific whereas others follow more general principles. In this lecture we will focus on the choice between debt and equity as an example of the complexities involved in capital structure decisions. However, many of the arguments here extend in a straightforward way to the other dimensions of capital structure choice.