# Capital Structure Management

A company’s capital structure refers to the combination of its various sources of funding. Most companies are funded by a mix of debt and equity, including some short-term debt, some long-term debt, a number of shares of common stock, and perhaps shares of preferred stock.

When determining a company’s cost of capital, weight the costs of each component of the capital structure in relation to the overall total amount. This calculates the company’s weighted average cost of capital (WACC). Then use the weighted average cost of capital to calculate the net present value (NPV) of capital budgeting for corporate projects. A lower WACC will yield a higher NPV, so achieving a lower WACC is always optimal. Refer to overseeing the capital structure as capital structure management.

## Capital Structure Strategy

Under stable market conditions, a company can compute its optimal mix of capital. A company’s optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital.

For example, if a company is financed by a combination of low-cost debt and higher-cost equity, then the optimal mix of capital would be some combination involving less of the higher-cost equity and more of the low-cost debt. In conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix.

### Capital Structure – Optimal Mix Example

Let’s say, for example, a company could raise between 40% and 60% of its needed funds with debt costing 8%. It could raise up to 10% of its needed funds with preferred stock issuance that costs 7.8%. Then it can raise between 30% and 50% of its funds by issuing common stock equity at 12.33%. What capital structure policy should the company employ to achieve its optimal capital mix?

After analyzing the numbers, and due to certain limitations and restrictions outside the scope of this simple example, the company came up with three choices:

```           Debt      Preferred Stock     Common Stock      WACC
Mix 1:      40%            10%                50%         10.145%
Mix 2:      59%            10%                31%          9.322%
Mix 3:      60%            10%                30%         11.679%```

As you can see, the company would be better off choosing Mix 2, which has the lowest WACC: 9.322%.

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# Acquisition Capital Definition

When a business decides to grow, you need acquisition capital. Define acquisition capital as the capital used to acquire other assets. You use this capital to purchase assets like equipment, inventory, software, or even a business itself. The purpose of these acquisitions are, ultimately, to grow the overall profits of a business. As such, the process of acquisition financing requires an ability in strategic analysis of the asset to be acquired, as well as the various financing options. Acquisition capital is used in one of two situations: when the growing business does not itself have the cash to grow or when the growing business will experience greater firm value from financing the purchase as opposed to paying out of the free cash flow of the company.

As you are expanding your company, it’s important to protect your company from “destroyers.”

## Acquisition Capital Explanation

Explained often as the fuel for company growth, acquisition capital is in many cases an industry of it’s own. This is due to the fact that so many companies desire to grow using existing methods and assets rather than creating new campaigns for marketing or cost management. Acquisition capital comes from two main sources: debt or equity financing. Because of this it is not exclusive to one type of firm; companies can provide only acquisition capital, only one type of acquisition capital, or provide other types of capital for operations. Additionally, many types of capital can be used for this, including factoring or personal finances. This makes the term acquisition capital as much an industry term as it is a simple label used to describe money shortly before it changes hands in a purchase.

### Acquisition Capital Debt

One of the two main forms of acquisition capital is debt financing. Many describe debt financing more commonly as a loan. When someone is paid back, usually with interest, in the form of loan payments rather than dividend payments one can be sure that debt financing is being used. In this way, an acquisition loan works the same as any other loan.

You can find acquisition capital, in the form of debt, through a variety of sources. First, one could simply access friends and family who can spare the money needed for the loan. We suggest that a business person do this under a specific agreement. Unfulfilled business agreement have damaged many close relationships.

#### Funding

Next, funding can come in the form of a bank loan. This will, for anyone who does not have access to a wealthy personal contact, almost always be the cheapest form of capital. One can access better interest rates, often, through government lending programs like the Small Business Association (SBA) or Patriot Express loans.

Often thought, mezzanine debt providers act as the middle ground between debt and equity financing. Here, one can receive a loan without collateral. Additionally, the loan contract also allows conversion of the debt to company common stock. Mezzanine debt, however, bears a higher interest rate due to the riskiness of the investment. It is usually provided by venture capital firms or private equity funds.

Asset based lending is another option for financing for acquisition. With an asset based lender, company uses their assets as collateral to back loans. The major disadvantage with this method is that using assets for collateral means that when loan agreements are not met, the assets are seized by the lending party. Logically, if the assets of a growing business are taken it is considerably more difficult to continue growth, if not all operations.

### Acquisition Capital Equity

Equity financing is another form of acquisition capital. Rather than receiving a loan which must be paid back, a company which receives equity financing provides company stock, either common or preferred, for the capital it receives. Equity financing is, essentially, payment in exchange for partial ownership in a company. Private equity and venture capital firms, the common providers of equity capital, will receive payback for their investment in one of 2 ways: company cash disbursements in the form of dividends or profit from the final sale of the company which includes their ownership stake. This means, often times, that equity financiers will take greater involvement in the company they have invested in.

### Acquisition Capital Example

For example, Eddy has started and grown a successful restaurant chain. Fighting the odds, he has grown his company from a single small shop to several locations. Using the recipes his grandmother once cooked, Eddy brings delicious food to the city while protecting his trade secrets. Recently, demand for his food has outpaced his ability to produce it. Eddy is now considering acquiring restaurants which serve French food, the cuisine that has risen him to success. Despite this goal, Eddy does not currently have the money to finance his own growth and will need acquisition capital to continue growing his business.

First, Eddy evaluates receiving a bank loan. He meets with a banker, an old high school friend, to discuss options for funding. Sadly, he discovers that he does not have the assets necessary to receive the standard bank loan. The bank will need to see, beyond Eddy’s dream, operations which Eddy has not yet achieved.

Eddy does research on Mezzanine and asset based lending. Here, he finds that he also does not qualify. For mezzanine, Eddy can not afford the interest rates required by lenders. For asset backed lending, Eddy does not have the proper set of company assets to convince the lender that he is worth their risk. Even if he did, Eddy does not see much benefit in promising away his tools for success.

#### Equity Financing

Eddy then evaluates equity financing. He looks at local and national private equity firms. Here, he finds experience requirements which he does not meet. Additionally, these firms will want increased control over Eddy’s business operations. Eddy is concerned that this might take away from his home-style cooking which has gained attention near his brick-and-mortar locations.

As Eddy is evaluating equity financing, he attends a family reunion. Here, he sees his uncle Ted for the first time in a while. An experienced restauranteur in his own right, Ted has also created a successful restaurant chain which serves Cajun food. Eddy has a very pleasant conversation with Ted and eventually expresses his needs. Ted, wealthy from his success, offers the idea that he could finance the budding series of French kitchens. They discuss the concerns of becoming business partners connected by blood relations. Though this is worry some, the two driven entrepreneurs resolve to continue the conversation later in the week.

Eddy looks forward to talking with Ted. By accessing friends and family, usually the cheapest and easiest of all forms of financing, he may be able to provide success for more than just himself. Additionally, Ted’s experience makes him a wealth of knowledge on acquisition; best practices are key to creating the standards that customers expect. Eddy makes a mental plan of what he will need to prepare in order to convince his uncle that he is worth an acquisition funding.

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## Financial Ratios

Monitoring a company’s performance using ratio analysis and comparing those measures to industry benchmarks often leads to improvements in company performance. Not to mention these ratios are often part of loan covenants. The following article provides an overview of the 5 categories of financial ratios and links to their description and calculation.

Use the following Financial Ratios to measure financial performance against standards. In addition, analysts compare these ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). Furthermore, the most useful comparison when performing financial ratio analysis is trend analysis. They are derived from the three following financial statements:

## 5 Categories of Financial Ratios

The five (5) major categories in the financial ratios list include the following :

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## Breaking Debt Covenants

What should you do if you are currently violating or are at risk of violating your debt covenants (breaking debt covenants)? The following video addresses this issue. The key is to be proactive and not wait for it to fix itself.

## Breaking Debt Covenants

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

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## Economic Reset

I just returned from the Microsoft Worldwide Partner Conference 2009 in New Orleans. At the conference I heard Steve Ballmer discuss the direction of the economy over the next several years. He believes that the world economy is going through an “economic reset”.

## Economic Reset

According to Ballmer ,the world economy becomes overheated every twenty-five to thirty years. Credit expands until the economy becomes so heated that risk is priced out of the market. In other words, there is so much money chasing too few good deals. Ballmer pointed out that total debt reached 350% of GDP in the United States at the height of the most recent boom. Prior to the Great Depression, that figure was only 150% of GDP. He believes that the economy won’t resume growing until that figure comes down significantly.

He contends that every 25 to 30 years the economy “resets” itself at a lower level thereby flushing out the high leverage and poor investments. Because this process takes time, he believes that the recovery will not be the quick rebound many predict.

Consequently, companies should be prepared to restructure their businesses to survive at a lower economic level. It will be difficult, if not impossible, to grow revenue in this environment. Instead he suggests that companies should focus on increasing market share.

### Economic Growth

Finally, when economic growth does resume it will not be fueled by debt. The growth will need to come from increased productivity. Because IT continues to change and most companies are stretching the life of their IT infrastructure there will be pent up demand once the economy grows.

So what should you or your company do to survive in these tough economic times? First, evaluate the effectiveness of your marketing dollars. For those marketing initiatives that work, you should increase your spending.

Second, invest in processes, tools, and training to improve your productivity, both personally and as a company. Acquire new skills and capabilities to prepare for when the economy does start growing again.

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