What’s the deal with ‘Capital Structure?’

Traditionally defined, capital structure refers to the percentage of capital type at work in a business. Broadly speaking there are two forms of capital, equity capital and debt capital. Capital structure can not only influence the survival chances of a firm, but it can also impact the return a company earns for its shareholders.  Therefore, in short, knowing about capital structure could help you make money.

Equity capital refers to money put up and owned by the share- holders in the form of contributed capital and retained earnings. Debt capital refers to the borrowed money that is at work in the business and this usually takes the form of short-term loans and bonds. The ratio of debt capital to equity capital is known as leverage. In the case of a failing company, debts will always be serviced before equity and therefore this has implications on how much money investors can make.

Need a little more explaining? Okay. Picture this: Ryanair have found a new way to cut the cost of producing aircraft and have now designed a plane with only one door. They have also decided to implement a new pricing strategy; 1st class – chairs with mediocre leg room, 2nd class – wooden stools (cushions provided at a supplement) and 3rd class – standing. The Economics Society  has hired out this plane for a Freshers tour. Bluebell residents opt for 1st class, JM residents opt for 2nd and Rootes, 3rd class. Now let the plane represent a company and the different classes represent different asset holders:  1st class and our Bluebell residents are short-term loan holders, 2nd class and JM residents are bond holders and 3rd class Rootes folk are shareholders. In terms of the plane’s capital structure, 1st and 2nd class are debt capital and 3rd class is equity capital.

Ok, still with me? Now, imagine, mid-flight, the plane hits turbulence… our company is no longer making money and is struggling to service its debts. With no intervention and capital restructuring the plane will crash . With only one exit, 1st class is the first to get to safety, second class is rather uncertain and third class are just clinging on to tiny morsels of hope. Hence we can see that for an investor shares are more risky than loans and bonds; equity holders are less likely to get out of the plane when it crashes. To attain the best profit, RyanAir must decide on how many 1st class, 2nd class and 3rd class seats to put in every plane. This is what a company must do when making decisions on its capital structure.

There you have it: Aeroplanes and Capital Structure.