Refresher Reading
Capital Structure
2024 Curriculum CFA Program Level I Corporate Finance
Introduction
Capital structure refers to the specific mix of debt and equity used to finance a company’s assets and operations. From a corporate perspective, equity represents a more expensive, permanent source of capital with greater financial flexibility. Financial flexibility allows a company to raise capital on reasonable terms when capital is needed. Conversely, debt represents a cheaper, finite-to-maturity capital source that legally obligates a company to make promised cash outflows on a fixed schedule with the need to refinance at some future date at an unknown cost.
As we will show, debt is an important component in the “optimal” capital structure. The trade-off theory of capital structure tells us that managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost of capital, which in turn maximizes company value. That optimal capital structure represents a trade-off between the cost-effectiveness of borrowing relative to the higher cost of equity and the costs of financial distress.
In reality, many practical considerations affect capital structure and the use of leverage by companies, leading to wide variation in capital structures even among otherwise-similar companies. Practical considerations affecting capital structure include the following:
- business characteristics: features associated with a company’s business model, operations, or maturity;
- capital structure policies and leverage targets: guidelines set by management and the board that seek to establish sensible borrowing limits for the company based on the company’s risk appetite and ability to support debt; and
- market conditions: current share price levels and market interest rates for a company’s debt. The prevalence of low interest rates increases the debt-carrying capacity of businesses and the use of debt by companies.
Because we are considering how a company minimizes its overall cost of capital, the focus is on the market values of debt and equity. Therefore, capital structure is also affected by changes in the market value of a company’s securities over time.
We tend to think of capital structure as the result of a conscious decision by management, but it is not that simple. For example, unmanageable debt, or financial distress, can arise because a company’s capital structure policy was too aggressive, but it also can occur because operating results or prospects deteriorate unexpectedly.
Finally, in seeking to maximize shareholder value, company management may make capital structure decisions that are not in the interests of other stakeholders, such as debtholders, suppliers, customers, or employees.
Learning Outcomes
The member should be able to:
- explain factors affecting capital structure;
- describe how a company’s capital structure may change over its life cycle;
- explain the Modigliani–Miller propositions regarding capital structure;
- describe the use of target capital structure in estimating WACC, and calculate and interpret target capital structure weights; and
- describe competing stakeholder interests in capital structure decisions.
Summary
- Financing decisions typically are tied to investment spending and are based on the company’s ability to support debt given the nature of its business model, assets, and operating cash flows.
- A company’s stage in the life cycle, its cash flow characteristics, and its ability to support debt largely dictate its capital structure, because capital not sourced through borrowing must come from equity (including retained earnings).
- Generally speaking, as companies mature and move from start-up through growth to maturity, their business risk declines as operating cash flows turn positive with increasing predictability, allowing for greater use of leverage on more attractive terms.
- Modigliani and Miller’s work, with its simplifying assumptions, provides a starting point for thinking about the strategic use of debt and shows us that managers cannot change firm value simply by changing the firm’s capital structure. Firm value is independent of capital structure decisions.
- Given the tax-deductibility of interest, adding leverage increases firm value up to a point but also increases the risk of default for capital providers who demand higher returns in compensation.
- To maximize firm value, management should target the optimal capital structure that minimizes the company’s weighted average cost of capital.
- “Optimal capital structure” involves a trade-off between the benefits of higher leverage, which include the tax-deductibility of interest and the lower cost of debt relative to equity, and the costs of higher leverage, which include higher risk for all capital providers and the potential costs of financial distress.
- Managers may provide investors with information (“signaling”) through their choice of financing method. For example, commitments to fixed payments may signal management’s confidence in the company’s prospects.
- Managers’ capital structure decisions affect various stakeholder groups differently. In seeking to maximize shareholder wealth or their own, managers may create conflicts of interest in which one or more groups are favored at the expense of others, such as a debt-equity conflict.