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Mergers and Acquisitions Best Practice

Capital Structure: Implications

by John C. Groth

Table of contents

Executive Summary

  • Reducing the weighted cost of capital increases the net economic returns, and adds to company value.

  • Place the company in a position that it can choose what it wants to do, rather than have circumstances force it to take a course of action.

  • The use of too little debt (L) results in a lower stock price, and too much debt (M) also lowers the stock price.

  • The more uncertain an environment, the greater the importance of the choice of and the strategy for managing capital structure.

  • If a company’s business risk is very sensitive to economic cycles, a company should manage its debt/equity (D/E) ratio across the cycle.

  • Knowledge of capital structure theory and practice is important in stock repurchase programs, mergers and acquisitions, divestitures, leveraged buyouts, and strategies aimed at defeating takeover.

Introduction

A tax environment that allows for the deduction of interest charges, but not the deduction of dividends, results in an optimal capital structure for a company. The optimal structure results in a lower weighted cost of capital (WCOC) for reasons examined in the article, Capital Structure: Perspectives. This article examines the implications of capital structure, and some of the key factors that influence capital structure.

Key Implication: WCOC and Value

Recognizing the behavior of the WCOC when there are changes in the D/E ratio, we now review how the correct capital structure ultimately adds benefits in terms of economic margins and resultant value.

Figure 1 illustrates the origin of value, and the significance of lowering the WCOC that results from selecting the optimal D/E ratio for a company. Recall that value arises from earning a net economic return that exceeds the cost of capital. For example, the net present value of a project represents the dollar value of having earned economic returns in excess of the cost of capital while the capital is in a project.

In Figure 1, with no debt the economic returns are labeled NER @ D/E = 0. Moving down the WCOC curve in the diagram increases the net economic returns, with attendant increases in value. The WCOC is for projects that do not alter the business risk of the firm.

Figure 2 graphically illustrates the impact of capital structure on stock price, keeping in mind that as we go from no debt to an increasing D/E we are reducing the number of shares. The use of too little debt (L) results in a lower stock price, and too much debt (M) also lowers the stock price.

Moving from L to the optimal level is quite easy. Borrow money and buy back some shares. Moving from M back to the optimal level is, in theory, equally easy, but in practice may face challenges depending on market conditions. Capital structure strategy is discussed in the article, Capital Structure: A Strategy that Makes Sense.

The Core Implication

Reducing the weighted cost of capital increases the net economic returns, and adds to company value. Remember that the relationship between WCOC and value is non-linear, making the choice and management of D/E particularly important.1

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Further reading

Articles:

  • Israel, Ronen. “Capital structure and the market for corporate control: The defensive role of debt financing.” Journal of Finance 46 (1991): 1391–1409.
  • Lewellen, W. G. “A pure financial rationale for the conglomerate merger.” Journal of Finance 26 (1971): 521–37.
  • Prezas, Alexandros P. “Effects of debt on the degrees of operating and financial leverage.” Financial Management 16:2 (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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