Steps to Growth Capital Self-Study GuideStep 2

2.6 Choose the Right Capital Mix

Mix of Debt and Equity

The mixture of debt to equity is a key aspect of a firm's capital structure. Since giving up equity means giving up "control" in some sense, the debt to equity mix is sometimes described as being high or low "leverage." When you finance with debt, you retain equity and control; so you, as the owner, maintain more leverage. On the other hand, when you finance with a high proportion of equity, you give up some control and therefore have less leverage.

High leverage

Debt financing covers the bulk of your needs.

 

Medium leverage

Equity and debt financing are balanced.

 

Low leverage

Equity investments fund the bulk of your needs.

How a Company Decides on Its Mix of Debt and Equity Financing

In choosing the right mix of debt and equity, you must consider three issues: your projected cash flow to repay debts, the relative cost of the different types of financing, and the impact of sacrificing some ownership and control. For example, the high leverage approach (where you borrow to fund your expansion) may not be possible if you don't have adequate cash flow to pay back what you borrowed. On the other hand, the low leverage approach (giving up equity in your business) may not appeal to you.

Choosing the Right Mix

Here is an example of how a company makes a decision on its mix of debt and equity financing. Imagine the company needs $1 million; it's buying equipment worth $900,000 and needs additional permanent working capital of $100,000. Consider the information, and decide which of these three approaches is best for this firm:

• high leverage (100% debt);
  
• medium leverage (60% debt/ 40% equity); or
  
• low leverage (100% equity).

Data

The useful life of the equipment will be 15 years.

The cash flow calculations assume that term debt is borrowed at 15% and subordinated debt at 10%.

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