Introduction

Capital structure refers to the way a corporation finances its assets through some combination of debt, equity or hybrid securities. A firm’s capital structure is then the compensation or structure of its liabilities. Few financial decisions have as significant an impact on a company’s equity value and future livelihood as the management of its capital structure and credit ratings. Companies manage capital structure through debt or equity repurchases, dividend increases, acquisitions, new investments and risk management.

Companies can raise capital through two main types of sources: debt and equity. We can also consider third category of sources called hybrids which are a mix of debt and equity and don’t completely fall in either of the categories. These are illustrated below.

Debt financing
Debt financing is a strategy that involves borrowing money from a lender or investor with the understanding that the full amount will be repaid in the future, usually with interest. In contrast, equity financing – in which investors receive partial ownership in the company in exchange for their funds –does not have to be repaid. In most cases, debt financing does not include any provision for ownership of the company (although some types of debt are convertible to stock). Instead, small businesses that employ debt financing accept a direct obligation to repay the funds within a certain period of time. The interest rate charged on the borrowed funds reflects the levels of risk that the lender undertakes by providing the money.

Sources of debt.

Bank loans:
By far the most important type of debt financing is a regular loan. Loans can be classified as long term, short term or a credit line. They can be endorsed by co-signers, guaranteed by the government or secured by collateral such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds or the items purchased with the loan. Most banks tend to be fairly risk averse and proceed cautiously when making loans. As a result, it may be difficult for a young business to obtain this sort of financing. Commercial banks usually have more experience in making business loans than do regular savings banks.

Private Sources:
Many entrepreneurs begin their enterprises by borrowing money from friends and relatives. The main advantage of this type of arrangement is that friends and relatives are likely to provide more flexible terms of repayment than bankers or other lenders. In addition these investors may be more willing to invest in an unproven business idea, based upon their personal knowledge and relationship with entrepreneur, than other lenders. A related disadvantage; however is that friends and relatives who loan money to help establish a small business may try to become involved in its management. Experts recommend that small business owners create a formal agreement with such investors to help avoid future misunderstandings.

Corporate Bonds:
A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money effectively in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category. Corporate bonds are often listed on major exchanges and ECNs, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. Corporate Credit spreads may alternatively be earned in exchange for default risk through the mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreads on corporate bonds can be significantly different.

External Commercial Borrowing:
External Commercial Borrowings (ECBs) are defined to include commercial bank loans, buyers’ credit, suppliers’ credit, securitized instruments such as floating rate notes and fixed rate bonds etc., credit from official export, credit agencies and commercial borrowing from the private sector window of Multilateral Financial Institutions such as International Finance Corporation (Washington), ADB, IFC, CDC. Even loans from Foreign Equity Holders are considered as ECBs. Thus ECBs mean foreign currency loan raised by residents from recognized lenders. Financial leases and Foreign Currency Convertible Bonds are also covered by ECB guidelines.

Foreign currency bonds:
A type of convertible bond issued in a currency different than the issuer's domestic currency. In other words, the money being raised by the issuing company is in the form of a foreign currency. A convertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock.

Financial Lease:
Also known as a capital lease, a financial lease is a situation in which a finance company or other lesser purchases an asset and then leases that asset to a client or lessee for a specified amount of time. At that point, the client takes possession of the asset and is free to utilize the asset for the duration of the lease agreement. Once the client has fulfilled the terms of the asset from the finance company at an extremely low price.

Equity Financing
Equity financing is the money raised for company activities by selling common or preferred stock to individual or institutional investors. In return for the money paid, shareholders receive ownership interests in the corporation. It is also known as share capital. Equity finance comes in various forms and is principally provided by venture capitalists and business angels. Equity finance may be defined as a method that is used in order to generate share capital resources from external investors with the share capital being provided in lieu of company shares. Equity finance is normally invested with the assumption that medium to long term profits may be made.

Sources of equity
Equity for a project or a business can be raised through various sources. Some of them are

Informal Sources
Informal sources refer to people or businesses who may be interested in investing in a business but who are not set up to act as professional investors or are actively looking for investment opportunity. They may be promoters, family, friends, trade partners and employees.

Angel investors
An investor who provides financial backing for small startups or entrepreneurs is an angel investor. Angel investors are usually found among an entrepreneur’s family and friends. The capital they provide can be a one-time injection of seed money or ongoing support to carry the company through difficult times.

Venture Capital
Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

Private Equity
Equity capital that is not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.
Public Issue
Corporate may raise capital in the primary market by way of an IPO, rights issue or private placement.

IPO
An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, to possibly monetize the investments of early private investors, and to become publicly traded enterprises. A company selling shares is never required to repay the capital to its public investors. After the IPO, when shares trade freely in the open market, money passes between public investors. Although an IPO offers many advantages, there are also significant disadvantages. Chief among these are the costs associated with the process, and the requirement to disclose certain information that could prove helpful to competitors, or create difficulties with vendors. Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertaking an IPO do so with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide a valuable service, which includes help with correctly assessing the value of shares (share price), and establishing a public market for shares (initial sale). Alternative methods, such as the Dutch auction have also been explored. In terms of size and public participation, the most notable example of this method is the Google IPO. China has recently emerged as a major IPO market, with several of the largest IPO's taking place in that country.

Private Placement
The sale of securities to a relatively small numbers of select investors as a way of raising capital. Investors involved in private placements are usually large banks, MFs, insurance companies and pension funds. Private placement is the opposite of a public issue in which the securities are made available for sale on the open market.

Rights issue
A rights issue provides a way of raising new share capital by means of an offer to existing shareholders inviting them to subscribe cash for new shares in proportion to their existing shareholders. A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders who are being asked to provide extra funds but not too low so as to avoid excessive dilution of EPS.


Hybrids
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share. Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares. A hybrid security is structured differently and while the price of some securities behaves more like fixed interest securities, others behave more like the underlying shares into which they convert. Some of the types are:

Preference Shares
Preferred stock also called preferred shares, preference shares or simply preferreds is an equity security with properties of both equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation”. Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.

Convertible Debentures
In finance, a convertible note (a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. The convertible bond markets in the United States and Japan are of primary global importance. These two domestic markets are the largest in terms of market capitalization. Other domestic convertible bond markets are often illiquid, and pricing is frequently non-standardized.

Warrants
A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are often included in a new debt issue as a "sweetener" to entice investors. The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company.