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
Corporate Finance Blog AMS 