Is there an optimal capital structure?

Here we are again with our next post. Now we have given you an introduction in what is meant by capital structure, we can go a step further. Perhaps you were thinking while you were reading the previous post; is there an optimal capital structure for companies? This post will answer that question.

To understand whether there is an optimal capital structure, we have to explain a few things first. As we have introduced in our previous post, there is a pecking order theory. This theory describes the order companies prefer to finance themselves are: 1.Internal finance; 2.Debt; 3.Newly issued equity. There are different reasons why companies prefer this order of financing and the primary reason is the cost of capital. Companies ideally want to pay as little as possible for their financing because by doing so, they increase their margin. To finance corporate activities by capital obtained from own activities, such as retained earnings, is the cheapest form of financing. Contrarily by using debt, a company has to pay interest to the lender. Lastly, newly issued equity is the most expensive because shareholders are subordinated in case of bankruptcy. Thus, companies are always looking for the cheapest form of financing.

If we link this to our initial question, is there an optimal capital structure for companies? we can say: Yes there is! The optimal capital structure for a company is one where the weighted average cost of capital (WACC) is minimized. But does that mean that every company has to finance itself internally? Ideally yes, but in practice it is hardly possible because the internal generated capital is not sufficient to finance the whole business. Since debt is cheaper than equity, companies prefer to use debt above equity. As an example, imagine you’re a bank, and a firm that is fully financed with debt comes to you for financing. You (the bank) will ask a higher interest because there is no equity involved so the shareholders of the firm are not financially involved and the risk of bankruptcy is higher. However, if the company, which is fully financed with equity, asks you for financing the interest rate charged for borrowing the money will be lower because the credit risk is lower. Thus, we can conclude from this example that the cost of capital is not only dependent on the type of capital, but also on the capital structure itself. Thereby, the optimal capital structure differs from industry to industry, meaning there is no “one rule fits all” determining an optimal capital structure that all companies can apply. However, as mentioned earlier, the optimal capital structure is when a firms WACC is minimized. This is illustrated in the graph below:

We’re done for now. Please leave a comment if something is unclear and we hope to see you all at our next post.

Mark-Paul, Tom, Mark

Capital Structure

How have the financing needs of multinational companies changed in a pre and post financial crisis in both the developed and emerging market economies? In determining the financing needs of a firm, one needs to examine its capital structure. Capital structure refers to how firms finance their overall operations and growth opportunities by using various sources of funding. Traditionally, firms finance themselves by using either debt, equity or a combination of the two. Modigliani-Miller (M&M) proposition 1, investigates the capital structure of firms under perfect market conditions. A perfect market is defined as a market where there are no transaction costs, no taxes, homogenous goods and that all firms are price takers, meaning they cannot influence the price of the goods. In this setting, M&M claim that regardless of their financing means, a firm’s capital structure does not change the value of a company under the perfect market conditions. Furthermore, the pecking order theory in corporate finance states that the cost of capital becomes more expensive for company’s due to the asymmetrical information between insiders and outsiders of the company. Specifically, the pecking order theory proposes that firms prefer to use internal funding through retained earnings or cash, followed by debt and lastly newly issued equity. This intuitively makes sense because using internal funding through the profits earned allows firms to use this excess capital to be reinvested in its operations. If internal funding is not sufficient, a company can reach out to external borrowings using debt since it is cheaper than newly issued equity. By externally borrowing through debt, the company overcomes the issue of asymmetrical information with its creditors since has a legal obligation to repay the loans granted to it, which to the contrary, is not the case with dividends and shareholders. Additionally, debt provides companies to take advantage of the tax shield since interest payments are tax deductible, which, as a result, increases the firm’s bottom line and decreases the firms cost of capital. As a last resort, a firm can choose to issue new equity to shareholders, but at a great expense due to the large investment banking fees the company must pay to complete the transaction. However, firms can profit from the newly issued equity when they have a high share price during a booming stock market. Although there is no simple way to determine the optimal capital structure of a firm, there are many other factors that influence the decision in how firms finance themselves such as the specific industry they are in, the lifecycle stage they are in, as well as, major macroeconomic factors.