A company’s mix of sources of long-term financing is called its capital structure. This financing typically involves sources of long-term capital, including common equity, preferred stock, and bonds. To keep the cost of raising capital low, many businesses subscribe to a capital structure policy. Systems vary from company to company, but may include policies such as weighting capital, financial leverage variability, sinking funds, financial structure design, and capital structure theory.
Many financial managers use weighted average calculations as part of the business’s capital structure policy because it factors in the cost of raising each type of capital. A business may be able to secure more funds by leveraging debt than by offering stock, but, due to interest and repayment fees, the debt might cost more in the long term. Or, it might not. Weighing each source of capital with its cost offers insight into the true value of money from each source of funds within the capital structure.
The degree of financial leverage given to each source helps quantify the variability of the financial weight of debt financing. A company using a leverage capital structure policy figures that the amount of debt affects other aspects of the capital structure, including stock prices. When figuring for leverage variability, a financial manager generally attempts to determine how much adding new debt will affect other sources of capital. The affect of more debt-funding is often contingent on the amount of debt the company already holds.
Businesses using bonds as a source of money include a sinking fund as part of the capital structure policy. A sinking fund is a cash reserve set aside for bonds that bondholders choose to cash in before the bonds have fully matured. Initial funding from bond calculations assume that bond debt will always be outstanding, and that, when it matures, the debt from the bond will be floated to a new one. Since bondholders do sometimes cash out bonds, the company must maintain a sinking fund, and weigh the cost of it when making capital structure calculations.
When designing a company’s overall capital structure policy, financial managers calculate the optimal mix of sources of funding. Determining what amount of securities, equities, and debt will offer the best financing is partly calculated by the business’s assets and other holdings. The financial manager’s take on capital structure theory also plays a part in policy creation. Some theories warn that companies should avoid debt financing, while other theories claim that debt has little to no effect on a business’s financial health.