CHAPTER 7 CAPITAL STRUCTURE AND LEVERAGE

7.1 Debt and Equity Capital

Capital structure refers to the mix of capital a firm would use in financing its business operation. Although such a mix generally includes all types of capital involved in the firm's finances such as preferred and common stock, short- and long-term debt, paid-in capital, and retained earnings, the term has been traditionally referring to two major types of capital and how they relate to each other. It has been often about the debt capital versus equity capital, their proportions, and their impact on the firm's financial performance.

Debt Capital

Debt capital refers to any form of borrowed funds that must be paid back according to a certain agreement or contract specifying the key terms such as interest, way and frequency of payments, default conditions, and the like. Based on the extension of time of repayment, there are three types of debt to finance a business.

  • Short-term debt, which is a money commitment that has to be paid back within a year such as bank loans or trade credit. A short-term bank loan is often an unsecured loan, and the trade credit is often as good as the borrower's credit rating. This type of debt is usually incurred by a small business upon its occasional needs such as to stock up material on good sale or to beef up seasonal inventory. In such cases, the borrowed funds would be paid off when the related product is sold making such debt as self-liquidating.
  • Intermediate debt, which ...

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