What it means
The capital structure is simply the list of funding sources on the right-hand side of the balance sheet. A capitalisation change reshuffles that list, and because debt and equity carry different costs, risks and rights, the reshuffle has real consequences.
Nothing about the trading operation needs to change for the company to become a different investment. The commonest reasons are growth, repair and tidying up.
A company issues shares to fund expansion, converts debt into equity to survive a crisis, or borrows to buy back shares when it believes its own equity is cheap. Each of those three motives leaves the business with a very different risk profile.
Borrowing to replace equity raises the return on the remaining shares when trading is good, because a fixed interest cost is spread over a smaller equity base. The same arithmetic works against the company when profits fall, since interest must be paid before shareholders receive anything.
This is financial leverage, and it cuts in both directions. Share splits and bonus issues are also capitalisation changes, though of a cosmetic kind.
They change the number of shares and the price per share without altering the total value of the equity or the company's ability to pay its debts. Confusing these with a real injection of money is a common error.
The practical work around any such change is checking what it breaks. Debt covenants, shareholder agreements, option plans and earnings guidance are all written against a particular structure, and a change can trigger a breach or a repricing.
The finance team should model the position after the change before the decision is taken, not after.
In practice
Real-world examples.
Example
A software company raises $30,000,000 by issuing new shares to fund expansion into two new countries. Existing shareholders see their percentage holdings fall by about a fifth, but the business gains cash with no repayment obligation and no interest cost.
Example
A struggling retailer agrees with its lenders to convert $45,000,000 of debt into shares. Interest payments stop, the balance sheet is repaired, and the former lenders end up owning 70% of the company while the original shareholders are left with 30%.
Example
A mature utility with steady cash flows borrows $200,000,000 at a fixed rate and buys back 8% of its own shares. Earnings per share rise immediately, but the credit rating agency puts the company on review because interest cover has fallen from eight times to five times.
Formula
Calculation
Gearing = total debt / (total debt + total equity)
Consider a company funded by $20,000,000 of equity and $5,000,000 of debt, so total capital is $25,000,000 and gearing is 5,000,000 / 25,000,000 = 20%. The board decides to borrow a further $15,000,000 and spend all of it buying back shares. Debt becomes 5,000,000 + 15,000,000 = $20,000,000, equity becomes 20,000,000 - 15,000,000 = $5,000,000, and total capital is unchanged at $25,000,000. Gearing is now 20,000,000 / 25,000,000 = 80%, so the operating business is identical while the investment is four times as geared, and if interest costs 6% the annual charge rises from $300,000 to $1,200,000.Case study
Seen in the real world.
Ormsby Dairies is an illustrative and clearly fictional food producer whose founding family owned 100% of a debt-free business with $18,000,000 of equity. To fund two new plants the board compared issuing shares to an institution with borrowing the money.
Issuing shares would have raised $12,000,000 and handed the institution 40% of the company. Borrowing the same amount pushed gearing from zero to 12,000,000 / 30,000,000 = 40% and added interest of $720,000 a year at 6% against operating profit of $4,500,000.
The family chose debt, keeping full ownership, and the plants performed as planned. The illustrative point is that both options funded the same investment, yet one diluted ownership permanently while the other added a fixed annual charge, and the right answer depended on how confident the family was in the cash flows rather than on which route looked cheaper on paper.
Watch out
Common mistakes.
- Treating a bonus issue or share split as if new money had entered the business, when both simply rearrange existing equity among the same owners.
- Judging a debt-funded buyback only by the rise in earnings per share, while ignoring the fall in interest cover and the higher risk of breaching a covenant.
- Making a structural change before reading the covenants and shareholder agreements, so a technical breach is discovered after the transaction has completed.
Questions
People also ask.
Does a capitalisation change affect the value of the business?
The operating value usually stays the same, but the value of the equity can move because risk, tax relief on interest and the order of claims have all changed.
Why would a company deliberately increase its gearing?
Because interest is normally tax deductible and debt is cheaper than equity, so moderate borrowing can raise returns to shareholders, provided profits are predictable enough to cover the payments.
Is a rights issue a capitalisation change?
Yes, because it brings in new money in exchange for new shares, which changes both the size and the composition of the capital structure.
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