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Trace how a firm's capital structure shifts as it moves through its life cycle

CFA® Level I · Corporate Finance · Capital Structure · CI.1.b

The idea

A young company with uncertain cash flows and few tangible assets is funded almost entirely by equity, because lenders have neither predictable repayment nor collateral. As revenue becomes recurring and assets accumulate, debt capacity appears and borrowing costs fall. A mature company with stable cash flows can carry substantial leverage and often does, using debt to fund buybacks or dividends once reinvestment opportunities thin out. In decline, falling cash flows make existing leverage more dangerous even without any new borrowing, because the same fixed obligations now sit on a smaller base.

A practice question

From the question bank, with the reason each wrong option is wrong.

Why are early-stage companies funded predominantly by equity?

  1. Equity is cheaper than debt because it carries no fixed paymentWhy not: Shareholders expect the highest return of any capital provider. Having no fixed payment does not make equity cheap.
  2. Their cash flows are unpredictable and collateral is scarce - correct
  3. Debt markets are closed to companies that are not yet listedWhy not: Private companies borrow from banks all the time. What holds back a start-up is the lender's lack of confidence and collateral.

The question is why a young firm uses shareholders' money rather than loans. Lenders want two things: confidence of being repaid, and something to take if they are not. A start-up with few sales and few assets offers neither, so banks hold back. Equity investors accept the risk because they share in the upside if the business grows. Equity is the more expensive money, since shareholders demand high returns, but it is often the only money on offer. Idea: the less predictable the cash flow, the less debt a firm can carry.

A harder one

Why does a mature company often borrow to fund buybacks or dividends?

  1. Because debt is tax deductible only when used for distributionsWhy not: The deduction attaches to the interest, whatever the borrowing funded.
  2. Because regulators require a minimum payout ratioWhy not: No general payout requirement exists for ordinary companies.
  3. Because reinvestment opportunities have thinned out - correct

A mature company has steady cash flows, so lenders are happy to lend to it. But it has few new projects worth funding, because reinvestment opportunities have thinned out. Rather than hold idle cash, it returns money to shareholders through dividends (cash payments) or buybacks (the company buying back its own shares). It may borrow to do so, which moves it towards more debt in its funding mix. Formula: Debt ratio = Debt / (Debt + Equity), and it rises. Tax rules and payout requirements are not what drives the choice.

The hardest tier

A company's revenue begins declining while its debt level is unchanged. Why does its financial risk rise?

  1. The same fixed obligations now sit on smaller cash flows - correct
  2. The interest rate on its existing debt rises as revenue fallsWhy not: Fixed-rate debt keeps its coupon, and floating-rate debt resets with market rates, not with the borrower's revenue.
  3. The value of its debt is revalued upward as equity value fallsWhy not: Debt is a fixed claim. Its face amount does not rise when revenue falls, which is why the burden relative to cash flow grows.

Financial risk is about whether cash flow can cover fixed payments such as interest. The debt does not shrink when revenue falls, so the same bill sits on less cash. Formula: Interest coverage = Operating income / Interest expense. For example, with interest of $20 million, operating income of $100 million gives 100 / 20 = 5.0 times. If operating income falls to $40 million, coverage is 40 / 20 = 2.0 times, with no new borrowing. Lower cover means a higher chance of missing payments.

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