What is Capital Structure?
Capital structure is the combination of debt, equity, and hybrid instruments (such as preferred shares or convertible instruments) a company uses to finance its assets and operations. The optimal capital structure balances the tax benefits and lower cost of debt against the financial distress and bankruptcy risks that high leverage creates.
How It Works
- Estimate the cost of each capital source (debt, equity, hybrids).
- Compute the weighted average cost of capital (WACC).
- Use the trade-off theory to balance tax shield benefits against distress costs.
- Consider the pecking order theory: internal funds, then debt, then equity issuance.
- Adjust capital structure dynamically using debt issuance, buybacks, and dividend policy.
Saudi Context
Saudi banks (SAMA-regulated) operate with thin equity-to-assets ratios consistent with Basel III. Non-bank Saudi corporates traditionally use moderate leverage; family-owned holding groups have started tapping the sukuk market more aggressively post-Vision 2030. PIF portfolio companies often carry growth-stage capital structures with significant minority equity injections alongside debt.
Example
A company holds SAR 600 million of debt at 6% pre-tax (4.8% after-tax) and SAR 900 million of equity at 11% cost. WACC = (600/1,500)*4.8% + (900/1,500)*11% = 1.92% + 6.6% = 8.52%. Adjusting the mix affects WACC and therefore enterprise value.