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

CFA® Level I · Corporate Issuers · 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 always cheaper than debt for a young firmWhy not: It is structurally more expensive, since its return is not deductible and its claim ranks last.
  2. Their cash flows are unpredictable and collateral is scarce — correct
  3. Regulation prohibits start-up companies from borrowingWhy not: No such prohibition exists; lenders simply decline, or price the loan beyond reach.

Lenders need confidence in repayment and something to claim if it fails. A young company offers neither, so equity investors — who are paid from the upside — bear the risk instead.

A harder one

Why do mature companies often increase leverage even when they need no new capital for investment?

  1. To reduce the tax shareholders pay on dividendsWhy not: Dividend taxation falls on the shareholder and is not affected by how the company is financed.
  2. Because regulators require a minimum debt ratioWhy not: No such requirement exists outside regulated financial institutions.
  3. To fund buybacks or dividends using the tax shield — correct

With fewer attractive projects, returning capital becomes the better use of cash, and debt funds it more cheaply than equity after tax. Stable cash flows make the fixed obligation tolerable.

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. Interest rates automatically rise on existing debtWhy not: Fixed-rate debt keeps its coupon, and even floating-rate debt does not reprice because revenue fell.
  3. Covenants convert the debt into equity automaticallyWhy not: Ordinary covenants do no such thing; they restrict behaviour and can trigger default.

Leverage is a ratio, and the denominator is shrinking. Interest cover deteriorates without any new borrowing, which is why declining businesses are dangerous places for fixed obligations.

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