Robert A. Bonavito, CPA PC

What is Capital Structure and Risk?

Today, we're going to talk about capital structure and risk. And when you talk about capital structure, I'm going to talk about it from the standpoint of a corporation with debt and equity. And it's very important that you understand this, because debt and equity interplay. And it can produce risk and rewards. Let me just give you an example. For example, let's say that you start a company with two shares of stock, and each stock is sold for $500. So, if you do that, the company will have a capital structure of $1,000. And let's assume that the company is making $100. So, what's your return on investment?

Your return on investment is 10%, right? $100 divided by $1,000. And what is your earnings per share? Your earnings per share is $50. Now, this is the power of understanding capital structure. Let's assume that the other share of stock was sold to your brother-in-law, and you want to buy him out. So you'll go and get a loan for $500, and then buy his share back. Now the capital structure of the company is what? $500 in equity and $500 in debt, the capital structure has changed.

But it's still $1,000. The enterprise value is still the same as it was before, when it was your equity. But look what happened to return on investment, and look what happened to earnings per share. Okay, now you only have $500 invested in the company, but you get $100 of earnings. So your earnings per share has gone from 10% to 20%, and the earnings, the dividends that you're getting, or the portion of the earnings has gone from $50 to $100. So you basically doubled the profitability of this company just by shifting from equity to debt. This is what a lot of financial people do at these big companies. It's very important. And it can have a dramatic effect on the profitability and the value of your stock, if you really do have a firm understanding of the capital structure.

Now, I know a lot of people have a knee-jerk reaction to debt, and they assume it's bad. But debt is not bad or good. It's how you use it, what you do with it. For example, let's look at someone who graduates from college. Studies have shown that college students that graduate from college and have debt are more successful than those that graduate from college without debt. Now that, you know, that seems counter-intuitive. But why? Why would that be true? Because the college students that graduate with debt have to be more driven. They can't take a job where they're not going to make enough money. They look harder for a job. They're not laying on the beach. They're working harder.

And debt does the same thing with a company. If you have a company that is loaded with cash, they waste a lot of the money, because there's nothing to keep them, you know, tight. They can spend on whatever they want. And so that's why debt is good. If you have a lot of look at Apple right now, they're loaded with money. It's probably good to get that money from them, because they're probably wasting it, and put some debt on there. Give that money to the shareholders.

So, when you think of capital structure, I want you to think of debt, and equity, and how it can dramatically affect the value of your investments, and also keep management focused on what they should be doing. If you have any questions on this video, feel free to give me an email.

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