Capital Structure

The discussion of an optimal capital structure has been around for a while, with theorists themselves not being able to agree what is best for companies. On one hand, Myers (1977) would argue that a company financed through debt, looks risky to investors, which may affect their future growth options. Where-as Jensen and Meckling (1976) argue that firms not taking advantage debt finance may be losing a competitive advantage over other companies. Therefore what is the best option?

Debt finance has always been a popular choice as it is cheaper than equity; this is due to lenders requiring a lower rate of return than ordinary shareholders. Plus there are tax benefits to debt finance, but what happens when a company becomes overloaded with debt?? Without a doubt, rarely do we look at a company’s financial statements without seeing they have a substantial amount of long-term loans. Heck one of the most important financial ratios we are taught is gearing, but whilst debt is seen as a reasonable and advantageous way of financing the business there does come a point when enough is enough. Conceptually a company should load up on debt until there comes a time when debt becomes equal to or more than equity. Once this occurs the benefits of debt finance become less sweet as further costs are incurred and the company runs the risk of becoming ‘Financially distressed’.

What does financially distressed mean for a company? Well, due to the company becoming increasingly risky because they are highly geared, lenders expect high interest for the loans they are proving and Banks etc. start raising interest on current debt due to their fear of defaulting on the payments. All in all to me it sounds like a very tricky and messy situation, a situation whereby companies get sucked into a vicious circle of borrowing to pay off debts whilst sustaining further debt. Certainly doesn’t sound like an ideal situation to me!

It is important to remember that companies are trying to create and maintain shareholder maximisation but I think extreme debt finance is a sure way of destroying value, as companies look less and less likely to offer good strong future prospects. It doesn’t matter if profits are high or low, interest has to be paid regardless. If we think back to a time when we have ever been in debt, even if it’s to our parents, it still hangs around like a dark cloud and doesn’t disappear until it is paid. . . and that is without interest.

So maybe being financed solely through equity doesn’t sound like such a bad idea. For a start it has the huge advantage of releasing the ball and chain and having the freedom to choose whether or not to pay dividends or retain and reinvest the money.

Those companies that were financed predominately/ fully through equity would have been rejoicing that they had when the economic crisis hit. The good years had seen companies load up on cheap debt to finance their business activities, but when 2008 hit these companies were left with the bad years, when all they could do was stand back and watch interest rates rocket and scratch their hands thinking of a strategy to get them out this mess.

Unfortunately thought, equity finance isn’t all its cracked up to be. Just like debt finance, equity comes at a cost. Instead of using loans to finance business activities a company uses shares instead, the catch being that shareholders can demand higher rates of return the more risky the project looks. Whilst bondholders have a built in level of security, shareholders don’t therefore they have to take precautionary actions to protect their investments.

It is understandable why companies try and chase the ideal of an ‘optimal capital structure’, surely the benefits of a mixed financed approach will be in the company’s best interest? But surely is theorist can’t decide whether there is such a thing as an ‘optimal capital structure’ then companies shouldn’t waste their time and resources trying to achieve the impossible? There are industry norms set, so investors can determine and set aside those companies with the most potential and less risk.

I think there is the issue of companies becoming too reliant on debt, with the worse case scenario of being insolvency. If the 2008 economic crash taught us anything, it is that loading up solely on high levels of debt finance is not the way forward. I agree that strategically debt finance can offer a competitive advantage and create shareholder value, but its whether companies can stop themselves from becoming too greedy and tipping the scales in the wrong direction. Maybe what is meant by optimal capital structure is a company keeping within the boundaries of finance and avoiding extremes therefore taking the advantages offering from debt finance but not becoming too highly geared and incurring financial distress costs.