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Home > Mergers and Acquisitions Best Practice > Capital Structure: A Strategy that Makes Sense

Mergers and Acquisitions Best Practice

Capital Structure: A Strategy that Makes Sense

by John C. Groth

Executive Summary

  • Perfect capital markets prescribe an optimal capital structure.

  • Imperfect capital markets, the seasonal and cyclical aspects of an economy, and the variability of market conditions argue that a company should have a target capital structure and an operating capital structure range.

  • Managers should be sensitive to changes in the business risk of a company, as these alter the optimal capital structure.

  • Maintaining good debt capacity makes sense and may favorably influence stock price.

  • Using bad debt capacity does not make sense from the viewpoint of stockholders and primary creditors.

  • Projects with good economic returns restore debt capacity and reduce the debt/equity (D/E) ratio. Bad projects that do not have attractive economic returns will have an adverse effect on capital structure, increase the D/E ratio, and eventually decrease the optimal D/E ratio.

  • Managers may adjust capital structure quickly or gradually. Whether quickly or gradually hinges on a variety of factors.

  • Capital structure is important for privately held firms.

  • Stock repurchase programs call for sensitivity and possible adjustment of debt capital so that one attains and/or preserves the desired capital structure.

  • Leveraged buyouts often distort capital structure. The decision to accept abnormal capital structures originates with those promoting the buyout and their perceptions about gains relative to personal capital at risk.

  • Issues related to control may influence the choice of capital structure.

Introduction

Perfect capital markets enjoy an array of assumptions, including no cost to bankruptcy, infinitely divisible financial assets and liabilities, no transaction costs, etc. Pursuing a selected optimal capital structure would allow minute adjustments, the issuance or redemption of small amounts of capital, and other conveniences. We would simply strive for the optimal debt/equity ratio depicted in Figure 1. Indeed, in this unreal world one would keep all the equity for control and to maximize wealth—and employ massive amounts of debt.1

Imperfect Capital Markets

The rudeness of imperfect markets prompts us to adopt a reasonable strategy that allows one to benefit from the tenets of capital structure theory while respecting the reality of markets and economies. Imperfect capital markets, bankruptcy costs, and that a company with financial flexibility may have attractive opportunities during periods of adverse market conditions argue for a strategy for the management of capital structure. Additionally, capital market participants may value a company with the financial flexibility that would allow it to pursue opportunities even (or especially) during periods of high market stress. A company with financial flexibility may find bargains during periods of distress.

In this article we first address background issues. Then we will move to recommendations. We will see that the suggested strategy does not seek to have the theoretical optimal debt/equity (D/E) ratio.

Good and Bad Debt Capacity

A company that has a less than optimal D/E ratio has unused good capacity. Normally a company with “good” debt capacity can borrow quickly on favorable terms to pursue an attractive opportunity. Thus, it can obtain capital quickly without the delays or possible undesirability of an equity offering.

Exceeding the optimal D/E ratio results in the company using “bad” debt capacity. History tells us that it is possible to do stupid things. Occasionally, we also see agents taking actions that promote their own interests, rather than acting in a way that benefits owners and creditors. Bad debt capacity adversely affects the weighted cost of capital, limits flexibility, and decreases stock price.

Issues and Strategy

Interrelationships

The expected streams of cash flows that originate in the business or operating side of a company service the sources of capital, including short-term liabilities such as accounts payable. Choices on the asset side of the company, and how successfully the company operates assets and interacts with the markets for goods and services, precipitate effects on the financing side of the company.

Although EBITDDA (earnings before interest, taxes, depreciation, depletion, and amortization) is not necessarily a cash flow in a period of time, for reasons explained in my article “Accounting and Economics—Critical Perspectives” (see qfinance.com), let us for simplicity assume that it is a cash flow. Those who have provided financing for the company have a keen interest in the level of expected cash flows, and the timing and the uncertainty of those cash flows. Hence, what the company chooses to do (its investments) and how well it employs those assets to generate cash flows (production, sales, collections, etc.) influence the business risk of the company.

The business risk, and factors such as tax rules and rates, influence the optimal financing for the company and, in turn, the financial risk of the company. Let us share some summary comments.

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Further reading

Articles:

  • Groth, John C., and Ronald C. Anderson. “Capital structure: Perspectives for managers.” Management Decision 35:7 (1997): 552–561.
  • Israel, Ronan. “Capital structure and the market for corporate control.” Journal of Finance 36:4 (1990): 321–349.
  • Miller, Merton H. “The Modigliani–Miller propositions after thirty years.” Journal of Applied Corporate Finance 2:1 (1989): 6–18.
  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance and the theory of investment.” American Economic Review 48:3 (1958): 261–297.
  • Prezas, Alexandros P. “Effects of debt on the degrees of operating and financial leverage.” Financial Management (Summer 1987): 39–44.
  • Prezas, Alexandros P. “Interactions of the firm’s real and financial decisions.” Applied Economics 20 (1988): 551–560.

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