Capital Structure (Debt vs. Equity)

A company's capital structure is the mix of debt (borrowed money that must be repaid with interest, regardless of how the business performs) and equity(money contributed by owners, who share in the business's profits and losses but aren't owed a fixed repayment) that a company uses to fund itself.

Using debt to fund a business, instead of only equity, is called financial leverage — the same idea as a physical lever amplifying a force, borrowed money amplifies the returns (and losses) experienced by the equity holders.

A company could, in principle, fund every investment purely with equity — never borrowing a cent. But per Cost of Capital, debt is consistently cheaper than equity, because lenders are repaid before shareholders and bear less risk, so they demand a lower return. That creates a real incentive to fund at least part of a business with debt rather than equity alone — doing so can lower the company's overall cost of capital and increase the return left over for shareholders, since the profit gets divided among fewer capital contributors once lenders are paid their fixed amount.

But that amplification cuts both ways. Debt has to be repaid on schedule no matter how the business performs — a bad year doesn't reduce a loan payment the way it reduces a shareholder's return. The more debt a company takes on, the larger that fixed obligation becomes relative to the business, and the more of the business's ups and downs land entirely on the shrinking pool of equity. Too much debt, and a bad year that a debt-free company could absorb comfortably can push a heavily-indebted one into default. This is why lenders and shareholders alike demand higher returns from more heavily indebted companies — the risk genuinely is higher.

Choosing a capital structure is choosing how much of this amplification a company wants: more debt raises the potential reward to shareholders in good years, but raises the potential for serious trouble in bad ones. There's no single right answer — a stable business with predictable cash flow (a utility company) can safely carry more debt than a volatile one (an early-stage startup) whose ability to make loan payments in a bad year is far less certain.

Two identical companies each hold $1,000,000 in assets and generate $120,000 of operating profit in a good year, or just $20,000 in a bad year — before any interest. Company A is funded entirely with equity. Company B is funded with $600,000 of debt at 6% interest and only $400,000 of equity.

Good year ($120,000 operating profit):
  Company A (all-equity):    $120,000 profit / $1,000,000 equity = 12.0% return
  Company B (leveraged):     $120,000 − $36,000 interest = $84,000
                              $84,000 / $400,000 equity = 21.0% return

Bad year ($20,000 operating profit):
  Company A (all-equity):    $20,000 profit / $1,000,000 equity = 2.0% return
  Company B (leveraged):     $20,000 − $36,000 interest = −$16,000
                              −$16,000 / $400,000 equity = −4.0% return

In the good year, Company B's shareholders earn a much higher return than Company A's — 21% versus 12% — because the fixed $36,000 interest cost leaves more of the upside concentrated in a smaller pool of equity. But in the bad year, Company B's shareholders actually lose money, while Company A's still earn a small positive return, because Company B's $36,000 interest payment is due regardless of how the business performed. Same underlying business, same operating results — leverage just redistributes the outcome, amplifying it in both directions for the equity holders.