Understanding capital structure opportunities
The capital structure of a company and the investment potential it offers can change when it uses leverage in the form of:
- Borrowing from banks and other lenders
- Issuing fixed-income convertible or preferred equity securities
How debt-fueled leverage can change a company's potential
Improve business performance
For many people, a mortgage is the catalyst that makes it possible to move from renting a home to owning one. Similarly, for businesses, debt is like a catalyst that can accelerate changes at a company, allowing it to grow more rapidly.
Improve return on equity for shareholders
Debt can have a variety of effects on a company's cash flow and earnings. The equity of companies that use debt successfully to grow operations can appreciate quickly, which is ultimately what matters to equity investors.
Leverage can increase return potential
1. Interest payments that come with debt add to a company's operating expenses and thereby reduce profits ($50 minus $10 of interest).
2. Because future income accrues to the same equity base, leveraged companies can offer attractive returns. As long as a company's cash flow can cover its interest payments, even a smaller profit margin can result in a higher return on shareholders' equity. Return on equity is a measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.
The capital structure has multiple components
The capital structure is a hierarchy of claims on a company. Each level has different features and a different level of protection — with bank loans offering the highest protection, and rights and warrants the lowest protection.
In most leveraged companies, bank loans tend to compose the largest slice of the corporate capital structure, in terms of value, followed by bonds, convertibles, equity, and rights and warrants.