Capital Structure – Is it possible to create the optimal capital structure?

As discussed previously, the main aim of a company is to maximise shareholder wealth. With this in mind, is it possible to achieve increased wealth for shareholders by changing the company’s capital structure? In simple terms, a firm can choose to finance their business through a mixture of debt and equity, but to what ratio? This is an issue I will explore, using current examples to highlight the different choices and preferences of certain businesses.

The optimal capital structure debate centres on the question of whether a company can minimise its cost of capital by adopting a particular combination of debt and equity finance. Companies seek a lower WACC as this is a fundamental determinant of market value; cost of capital is used as the discount rate in investment appraisal decisions (Watson & Head, 2013). Therefore, it is an important figure as it can determine a company’s strategic option set, in effect influencing future cash flows of the firm.

Norwegian oil producer, Det Norske Oljeselskap ASA, is currently trying to create an optimal capital structure (Holter, 2015) in order to restore wealth to shareholders. This is because share price has deteriorated over the past year as shown in the graph i have constructed below. A net loss of $287m was reported in the fourth quarter due to the significant drop in oil prices recently (Holter, 2015), causing the company to consider both sources of financing. CEO Karl Johnny Hesvik said the company would be able to raise more debt and may also issue new shares (Holter, 2015).

(Share price figures sourced from https://uk.finance.yahoo.com/q/hp?s=DETNOR.OL&b=9&a=03&c=2014&e=10&d=03&f=2015&g=w)

However, equity and debt both have their benefits and drawbacks. Firstly, issuing shares on the stock exchange can result in relatively hefty transactions costs. Equity finance is also considered highly risky; investors have no guarantee of either dividend payments or capital gains. They are also ranked lowest on the creditor hierarchy should the company go into liquidation (Watson & Head, 2013). Due to these uncertainties faced by the investor, a higher return is demanded to compensate for the risk taken, increasing the cost of equity capital.

Contrastingly, lenders require a lower rate of return than ordinary shareholders, due to finance providers having secure claims on income (interest payments) and in liquidation (Arnold, 2013). Moreover, further benefits include the tax advantage and much lower transaction costs than issuing shares (Arnold, 2013). Therefore, debt is a much cheaper source of finance than equity.

Taking these factors into consideration, you would assume maximising shareholder wealth through capital structure is simple – just load up on debt as it has a lower cost than equity. Job done!!

But why then do companies continue to finance through issuing shares? For example, last week the UK furniture chain DFS returned to the stock market after privatisation in 2004 (BBC News, 2015). DFS are seeking to expand internationally and view floating on the stock exchange as a valuable way of securing finance, expecting to raise £105m by floating 25% of the private equity-owned company (Monaghan, 2015). They plan to use the capital raised to reduce their current debt and provide access to a lower cost of financing (Chapman, 2015). This highlights the issue of acceptable levels of gearing, which companies must take into account when considering their capital structure.

Increasing levels of debt can increase risks. Although debt decreases WACC as it’s a cheaper source of finance, the cost of equity actually increases as shareholders will demand higher returns for the risks they are taking (Arnold, 2013). Investors view increased gearing as risky as the financial risks a business takes are amplified and the risk of financial distress and ultimately liquidation increase. Therefore WACC will increase, reducing the value of the company and shareholder wealth (Arnold, 2013).

I believe DFS may have wanted to reduce their levels of risk and financial distress by issuing shares on the stock exchange- a period of expansion could mean uncertain times ahead for the company. So a reduction in debt and therefore interest payments will be beneficial and DFS will also be under no obligation to pay shareholders dividends. However, DFS have been cautious and set their share price at the lower end of the market range, this reduces the value of the company to £543.2m, despite initially valuing the company at £585m (Chapman, 2015). This could reflect the fact that there is still debt in the balance sheet and investors may be weary of this.

Nevertheless, Nobel Prize winners Miller and Modigliani (1958) suggested that a company’s capital structure has no impact on the WACC and value of a firm. Thus, advising that no optimal structure exists. Miller and Modigliani (1958) argued that as the cost of equity rises with the level of gearing, the increase is exactly offset by the cost of debt being lower, constant and a larger proportion of the capital structure. This implies that both Det Norske and DFS could choose to load up on debt and their WACC would remain the same, despite investor’s worries of financial distress.

But their theory was widely criticised for being based on many assumptions such as perfect efficient markets existing, no tax and also no costs of financial distress (Miller & Modigliani, 1958). They later published updated versions that took into account the effect of tax (1963) and financial distress (1971) and their theory dramatically changed, suggesting an optimal structure was possible.

To conclude, I believe that an optimal capital structure does exist. However, there is not one set combination, I think it will vary from company to company depending on investors and managerial preferences. The current economic climate and situation of the business will also influence this structure. For example, since the financial crisis many managers have become more cautious of the level of borrowing their firm undertakes (Arnold, 2013) and I believe this is the case with DFS, choosing to source finance through equity rather than debt. As the dramatic drop in oil prices and industry conditions will influence Det Norske’s choice of future capital structuring.

Furthermore, companies are beginning to consider alternative methods of finance that managers perceive to involve less risk. BBC News reported that many Northern Irish start-up firms were choosing to by- pass the banks to finance start-ups and expansions and instead favour methods such as Crowdfunding, with 4% of the UK's small business funding coming from this source last year (BBC News, 2015). These new emerging methods may be preferred by investors as they see crowdfunding as lower risk than lending from the bank.

 

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2015, March 6). Furniture chain DFS returns to stock market. BBC News. Retrieved from http://www.bbc.co.uk/news/business

BBC News. (2015, March 8). Alan Watts: NI start-up firms 'bypassing banks' says leading entrepreneur. BBC News. Retrieved from http://www.bbc.co.uk/news/business

Chapman, M. (2015, March 6). DFS valuation drops £40m as it sets share price at lower end of range. Retail Week. Retrieved from http://www.retail-week.com

Holter, M. (2015, February 25). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Bloomberg. Retrieved from http://www.bloomberg.com

Miller, M.H. & Modigliani, F. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org 

Monaghan, A. (2015, February 6). DFS Furniture to float on stock market. The Guardian. Retrieved from http://www.theguardian.com
Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.