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Capital Structure: Optimal Composition

The Bigger Picture:

To start our discussion on how do companies decide on their composition of capital structure, it would be beneficial to take a step backwards, and glance at the bigger picture; prior to jumping into the details. Any company is brought into existence to increase the wealth of its owners; the shareholders. The company does so by generating economic returns through the process of taking “financial capital and [converting it] into assets…[to fulfill] customer needs” (Groth and Anderson, 1997). The financial capital utilized by the company, which becomes its assets, comes from shareholders’ funds (equity) and debt. It is the different percentage claims of the financiers (shareholders and debtors) that make up the capital structure of a company.

As companies are established to increase shareholder’s wealth, managers want to put in place a capital structure to achieve just that. Thus an “efficient mixture of capital reduces the price of capital … [and in doing so] increases net economic returns which, ultimately, increases firm value” (Groth and Anderson, 1997).

But reducing the price of capital is not the only task a company faces as it increase the wealth of its shareholders. A company face other variables such as:

-> Government taxes on the revenue it generates
-> Indirect bankruptcy claim costs, rendered through “higher interest rates” (Ross et al., 2008, p. 463), should the company default on its debts.
So, in selecting a capital structure, taxes and bankruptcy claims must also be taken into consideration; along with reduction of capital costs. Given such qualitative framework, the following questions arise: Is there an optimal capital structure for companies? Is a company’s capital structure a result of its operating context, or underlying principles?
In Principle:

Each company does have an optimal capital structure; and such structure is a result of underlying principles.

As stated briefly, four parties have claims over a company’s earnings: the shareholders (equity), the bondholders (which shall represent the debt portion), the government (taxes), and bankruptcy claims (indirect costs). As companies cannot influence directly the claims of the latter two [taxes and bankruptcy claims], it must do so by optimizing the debt-to-equity mix. “Stockholders choose the debt level to maximize the value of their equity taking into account the cost of default” (Harris and Raviv, 1990).

Modigliani-Miller (1958) have proved that the “value of [a] firm is completely independent of [its] capital structure” in the absence of taxes and bankruptcy costs. It was later demonstrated that “high leverage capital structures” (Miller, 1988) reduce corporate income taxes, as accounting principles require interest expense to be subtracted from earnings prior to tax calculation. With higher leverage [debt] capital structure, more money ‘in theory’ finds its way to shareholders/bondholders; since less of it goes to taxes. But one side effect of increased leverage is the increased risk of bankruptcy. Thus as a company’s leverage increases, so does its bankruptcy claims costs; which is reflected through increased interest rates on debts. With the increase of bankruptcy claims due to higher leverage, less money finds its way to shareholders/bondholders.

So in principal, the optimal capital structure of a company is when the tax shelter gains minus the bankruptcy claims costs is maximized. This should bring about the most wealth to the shareholder’s of the company. Effectively, “the use of the right amount of debt lowers the companies weighted cost of capital” (Groth and Anderson, 1997).

In Reality:

Though the above explanation of how to decide on an optimal capital structure makes perfect sense, it is all academia. “No equation exists to determine the optimal capital structure for a company” (Groth and Anderson, 1997). The actual market environment is much more complex to capture in mathematical formulas. Some factors that make it difficult to arrive to an optimal capital structure include (the list is not exhaustive):

-> “Investors’ receptivity to debt” (Milken, 2009): This is mainly influenced by the current market conditions.
-> A culture’s acceptability of debt: Culture plays a big role in “influences our values, which in turn affects our attitudes, and then behavior” (Chui et al., 2002).
-> Country factors: “Aggarwal (1981) [analyzed the] 500 largest European firms” (Chui et al., 2002) and concluded that country factors play a role when companies decide on their capital structure.
-> Free cash flow problem: Whereby if a company generates a lot of cash flows from the optimal capital structure, it would “waste it rather than pay it out to investors” (Myers, 1993) considering that a conflict of interest would be present between management and shareholders.
-> Deviation from industry norm issues: If a company structures its capital in a way where it deviates substantially from its industry norm, it might be frowned upon by lenders, making it difficult for the company to attain debt-financing.

Closing Notes:
Given the complexities of capturing all the variables that effect the optimal capital structure formula, then the capital structure composition is left to an educated guess at best: industry standards, operating context of the firm, stakeholder’s preference, etc. But as companies experiment with various capital structures, they would be inching ever closer or further to the optimal point. One statement that rings true, regardless of capital structure composition, is “it doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will” (Milken, 2009).
~ Youssef Aboul-Naja
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