Types of Risk

Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision components. Poor capital structure decisions can create a high cost of capital, thereby lowering the NPVs (Net Present Values) and making more of them unacceptable. Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects – and thereby increasing the value of the firm.

Types of Capital

Corporate bonds are a major source of debt capital. The cost of debt is lower than the cost of other forms of financing. Lenders demand relatively lower returns because they take the least risk of any long-term contributors of capital:

· They have a higher priority of claims against any earnings or assets available for payment.

· They can exert far greater legal pressure against the company to make payment than can holders of preferred or common stock.

· The tax deductibility of interest payments lowers the debt cost to the firm substantially.

Unlike debt capital, which must be repaid at some future date, equity capital is expected to remain in the firm for an indefinite period of time. The two basic sources of equity capital are preferred stock and common stock equity, which includes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock. The concern is the relationship between debt and equity capital. Further, because of its secondary position relative to debt, suppliers of equity capital take greater risk than suppliers of debt capital and therefore must be compe4nsated with higher expected returns.

How does the US stack up?

Overall, non-US companies have much higher degrees of indebtedness than their US counterparts (Healy, 2009). Most of the reasons for this are related to the fact that US capital markets are much more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries. In most European countries and especially in Japan and other Pacific Rim nations, large commercial banks are more actively involved in the financing of corporate activity than has been true in the United States (Healy).

Further, in many of these countries, banks are allowed to make large equity investments in nonfinancial corporations – a practice that is prohibited for US banks. Additionally, share ownership tends to be more tightly controlled among founding-family, institutional, and even public investors in Europe and Asia than it is for most large US corporations. Tight ownership enables owners to understand the firm’s financial condition better, resulting in their willingness to tolerate a high degree of indebtedness.

Healy, C.R. (August, 2009). Phoenix rising. Strategic Analysis Corporation.