Changes in capital structure: Overview, definition, and example
What are changes in capital structure?
Changes in capital structure refer to adjustments made by a company to its mix of debt and equity financing. Capital structure is the way a company finances its operations and growth through a combination of debt (loans, bonds) and equity (stocks or shares issued to shareholders). A change in capital structure can occur for various reasons, such as raising additional capital, paying down debt, issuing new shares, or repurchasing existing shares. These changes impact the company’s financial health, risk profile, and control over the business.
Why are changes in capital structure important?
Changes in capital structure are important because they directly affect a company's financial stability, cost of capital, and ability to manage its debt. Adjusting the balance between debt and equity can help a company achieve its strategic goals, such as financing new projects, expanding operations, or improving cash flow. For investors, understanding a company's capital structure changes is essential for assessing the company's risk and potential returns. Changes in capital structure can also influence shareholder control and voting rights, as well as the company’s overall valuation.
Understanding changes in capital structure through an example
For example, a company might decide to issue additional shares of stock to raise capital for a new product development project. By increasing the equity portion of its capital structure, the company dilutes the ownership of existing shareholders but does not incur additional debt. This change may make the company less leveraged and reduce its financial risk, but it could also affect the return on equity for shareholders.
In another example, a company might decide to take out a loan to finance a large acquisition. By increasing the debt portion of its capital structure, the company may gain immediate access to capital without diluting the ownership of current shareholders. However, taking on more debt increases the company’s financial risk, as it must repay the loan regardless of its business performance.
An example of a changes in capital structure clause
Here’s how a changes in capital structure clause might appear in a financing agreement:
“The Borrower agrees not to make any changes in its capital structure, including issuing new equity, incurring additional debt, or repurchasing shares, without the prior written consent of the Lender, except as otherwise provided in this Agreement.”
Conclusion
Changes in capital structure are a crucial aspect of a company's financial strategy. Whether through issuing new shares, taking on debt, or restructuring existing finances, these changes impact the company's financial risk, growth potential, and market perception. By carefully managing capital structure, companies can optimize their financial position and support long-term success, while investors can better assess risk and return opportunities.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.