1.5 Capital Structure and Payout Policy

Once a firm decides on which projects to pursue, it must then decide how to pay for the project. The decision on how to fund a project is known as a capital structure decision. There are three ways a firm can get the money, or capital, needed for a project: internal funds, external debt and external equity.

Internal funds available to a firm include retained earnings and cash on hand. Because the firm already has access to this capital, the firm does not need to go outside to get the money needed if using internal funds.

Debt is money that a firm borrows from outsiders to finance or provide capital for a project or investment. When a firm uses debt, it receives cash and then makes a promise to repay that cash. Debt has three primary characteristics: fixed future payments, possible default, and tax-deductible payments. Fixed future payments means that the money is repaid according to an agreement with the lender who will provide a schedule of when payment are made and how much is paid. Possible default means that if a firm does not pay as agreed, there will be negative consequences. Tax deductible payments means that a firm can deduct the interest paid on debt from their tax bill.

Another common term for debt is leverage. You may hear a firm described as "unlevered." This means the firm has no debt. You may also hear that a firm has "levered up." This means the firm has added debt. A firm may be described as "highly levered" which means it has a relatively high level of debt.

The other form of external capital for a firm is equity. When a firm issues equity, it receives cash and gives up an ownership stake in the firm. While debt providers do not own any part of the firm, equity holders do. How much ownership is given up depends on the specific issuance.

A firm becomes publicly traded at the initial public offering (IPO). At the IPO, the firm issues equity and receives cash. Investors who purchase the issued equity become part owners of the firm. Similarly, a firm that is already publicly traded can issue equity through a seasoned equity offering (SEO). An SEO follows the same general guideline of the firm gets cash and gives up ownership stake.

Payout policy refers to the decision a firm faces with respect to how or if they distribute profits. In other words, payout in this case means getting cash to shareholders. When a firm generates profits, it has three primary options: retain earnings, pay a dividend, or repurchase shares. If the firm retains earnings, there is no "payout." The firm keeps the funds.

One option to get cash to shareholders is to pay a dividend. A dividend is a cash or stock payment to shareholders. The most common type of dividend is a quarterly dividend. In this case, a shareholder receives a fixed amount of cash for every share they own at a quarterly interval. If a shareholder owns one share of a stock with a quarterly dividend of $0.10, then each quarter that shareholder would receive a check for $0.10 from the firm. A firm is not required to pay dividends at all and many do not.

The other main option to get cash to shareholders is through a repurchase. A repurchase is basically the reverse of issuing equity. When a firm repurchases shares, it pays shareholders cash and receives the equity or ownership from the shareholders.