Part 2 – Lesson 3
The Capital Structure Stack
When investors speak about capital structure, they are referring to how a company has been funded. We know that a company can be funded through debt or equity. There are different types of debt securities and equity securities, and as an equity investor, it is important to understand the entire capital structure to understand how cash flows to the company are prioritized.
The below table will provide a summary of some of the main types of financing and where they lie in the capital structure.
Type of Security Priority Notes Senior Debt Highest When a company raises senior debt, this borrowing receives the highest priority in the capital structure, which means that cash flows of the company must first go to paying the interest expense of senior debt and any required principal paydowns. If there is sufficient cash flow after paying down senior debt obligations, then, this cash flow will filter down to the remainder of the capital structure. Since lenders providing senior debt are taking the least risk in the capital structure, senior debt lenders will typically receive the lowest return. Said another way, the cost to the company for borrowing senior debt is lower than other forms of debt or equity. Senior debt can also be secured or unsecured. Secured debt provides additional comfort to the lender by specifying certain assets that can be used to paydown the loan amount in the event that the company fails to meet its repayment obligation. Unsecured debt is not secured by any specific asset of the company, but receives a general payment obligation by the company.
Subordinated Debt Next highest after senior debt Lenders who provide subordinated debt will demand a higher interest rate for taking a more junior position in the capital structure, so this will be a higher cost borrowing to the company than senior debt. To call something “subordinated,” there must be another borrowing in the company that this type of debt is subordinated to. For example, if a company has existing debt but needs to borrow more from a different lender, this new lender may agree to “subordinate” their loan to the other lender, which means that the new lender will agree to be second in line to be repaid. The compensation for being subordinated is a higher interest rate. Subordinated debt can also be secured or unsecured. Preferred Equity Next highest after all debt Preferred equity is a type of equity that sits above common equity but sits below debt and is often viewed as a hybrid between debt and equity. Similar to debt, preferred equity typically comes with a regular coupon that must be paid by the company. Typically, companies will pay anywhere from 5-8% as a “preferred dividend” to its preferred shareholders. The preferred dividend is not tax deductible to the company. Companies may elect to issue preferred stock to avoid taking on too much debt, if debt is not available at attractive terms, or if they do not wish to dilute the common equity holders.
Like common equity, preferred stock typically does not have a maturity date. While debt has to be repaid at a certain date, preferred equity is often perpetual, but companies typically have the right to pay it down if they elect. Unlike common equity, preferred stock does not share in the profits of the company (unless the preferred stock is convertible into common, which is a feature commonly added to preferred stock).
Common Equity Lowest Common equity is what investors buy and sell on a daily basis on the stock exchanges. Common equity holders take the most risk in the capital structure, and therefore, should theoretically earn the highest return in the capital structure. In the event of a company liquidation, common equity holders are the most junior in the capital structure, so they will receive proceeds only after all debt and preferred equity has been paid off.
When investors refer to share count, they are referring to the number of shares of common equity. The current stock price of a public company reflects the current market value per share of the common equity.
What is market value vs. book value?
You may often hear investors talk about market value vs. book value. It is helpful to remember that balance sheet items are usually reflected at book value.
For example, if Company A purchases a car for $30,000, the market value of this car may drop to $20,000 in one year. This means that if Company A were to sell this car in one year, they would receive the current, fair market value for that car of $20,000. However, this will not necessarily match with what the balance sheet says. If the company is depreciating the car over 10 years and using a $2,000 yearly depreciation expense, then, the value of the car will be shown as $28,000 in one year.
In this example, the $28,000 carrying cost of the car in the balance sheet is referred to as “book value,” whereas the price you could sell the car of $20,000 is the market value of the car. Balance sheet items almost always reflect book value, which saves accountants from constantly having to adjust for changing market values.
This also means that the balance sheet will reflect the book values of the debt and equity. For example, if John’s Pizzeria raises $100,000 of common equity in an IPO, then, the balance sheet value of the common equity will only be adjusted based on the following formula:
Starting Common Equity + Net Income – Dividends to Common = Ending Common Equity
The common equity on the balance sheet is not updated to reflect the market value of the equity. Instead, the common equity is shown at book value as determined by the addition of net income and subtraction of dividends. We can summarize book value of equity vs. market value below:
Book Value of Common Equity = Value of Common Equity as shown on the balance sheet
Market Value of Common Equity = Value as reflected by the current stock price of the company * total shares outstanding
When investors look to value a company, their goal is to determine the proper market value of the common equity.