LM07 Capital Structure

Part 1

1. Introduction

Capital structure refers to the specific mix of debt and equity a company uses to finance its assets and operations.

This reading covers:

• Factors affecting capital structure
• How a company’s capital structure may change over its life cycle

• Modigliani–Miller propositions regarding capital structure
• Optimal and target capital structure
• Competing stakeholder interests in capital structure decisions

2. Factors Affecting Capital Structure

Exhibit 1 from the curriculum shows the primary internal and external factors that affect a company’s capital structure.

We will discuss each of these in detail.

Internal Factors Affecting Capital Structure

Business model characteristics

A company’s business model can greatly impact its capital structure by influencing its ability to service debt. Key factors that differ among business models include:

• Revenue, earnings, and cash flow sensitivity
• Asset type
• Asset ownership

Revenue, earnings, and cash flow sensitivity:

Some companies like Vodafone in the telecom industry, have very stable revenue streams because a large proportion of their revenues are subscription-like, recurring revenues. This is generally viewed as a positive for its ability to support debt, because their revenues are less affected by fluctuations in the business cycle.

In contrast, companies in cyclical industries, such as Toyota in the automobile industry, have more volatile revenue streams that are highly sensitive to fluctuations in the business cycle. This is viewed as a negative for the company’s ability to support debt.

Also, companies with pay-per-use business models, rather than subscription-based models, are likely to have a lower degree of revenue predictability. This reduces their ability to support debt.

Generally, stable revenue streams should result in stable earnings and cash flow streams. But the company’s cost structure (the proportion of fixed and variable costs) also plays a role. Companies with higher operating leverage (operating leverage = fixed costs / variable costs) have high earnings and cash flow volatility as compared to firms with low operating leverage. Thus, high operating leverage reduces a company’s ability to support debt.

Exhibit 2 from the curriculum summarizes these relationships:

Asset Type:

A company’s assets can be broadly classified as:

• Tangible or intangible: Tangible assets are identifiable, physical assets like property, plant and equipment, inventory, cash etc. In contrast, intangible assets do not exist in physical form, such as goodwill, patents, property rights.
• Fungible or non-fungible: Fungible assets are those that can be interchanged or substituted for another asset of similar identity, eg money. In contrast, non-fungible assets are unique assets such as art pieces that are not mutually interchangeable or substitutable.
• Liquid or illiquid: Liquidity refers to the ability to convert an asset into cash without losing a substantial amount of its value. Some assets like marketable securities are very liquid. In contrast, some assets like real estate, property plant and equipment are illiquid.

From a creditor’s perspective, tangible assets are considered safer than intangible assets as they can better serve as debt collateral. So companies with mostly tangible assets (e.g. oil and gas, and real estate industries) can operate with a higher proportion of debt as compared to companies with mostly intangible assets (e.g. software industry).

Similarly, creditors prefer fungible liquid assets over non-fungible, illiquid assets.

Therefore, companies with greater fungible, tangible, liquid assets can support a higher level of debt.

Asset Ownership:

Some ‘asset-light’ companies may choose not to own assets but instead ‘out-source’ asset ownership to other parties. For example, Uber and Airbnb. This strategy, reduces the amount of assets on the balance sheet, reduces operating leverage, and allows companies to maximize their flexibility and ability to scale quickly.

The effect of this strategy on the ability to support debt is mixed, On one hand, the lower operating leverage can support higher debt levels. On the other hand, a lower proportion of tangible assets on the balance sheet reduces the ability to support debt.

Existing leverage

The existing financial leverage of a firm influences its capital structure decisions. Highly leveraged firms face a higher risk of default and, as a result, have less capacity to service additional debt. Underleveraged firms, on the other hand, can support additional debt relatively easily.

The following ratios are commonly used to determine a company’s ability to support additional debt (Exhibit 4 from the curriculum):

Exhibit 5 presents the relationship between the above ratios and the ability to support debt.

Corporate Tax Rate

In many countries, interest expense is a tax-deductible expense. As a result of the tax savings, a company’s after-tax cost of debt will be lower than the actual cost. The higher (lower) the firm’s marginal income tax rate, the greater (lower) the tax benefit of using debt in the firm’s capital structure.

Capital Structure Policies/Guidelines

Many companies establish capital structure polices that define the acceptable levels of debt in the capital structure. For example,

• debt/equity less than 0.5 times
• debt to operating cash flow less than 2.0 times
• debt as a maximum of X% of total capital

To come up with these thresholds, companies may start with debt covenants or rating agency thresholds and add a cushion or ‘margin of safety’ to ensure that the actual thresholds are not breached.

Another important consideration is whether their debt or equity issuance meets index provider requirements. Inclusion in a benchmark index can significantly affect the demand for these securities.

Third-Party Debt Ratings

Debt ratings are independent, third-party assessments of the quality and safety of a company’s debt. They are based on the analysis of the company’s ability to pay the promised cash flows. Debt ratings are an important factor in the practical management of leverage. Since borrowing costs are closely tied to the bond ratings, maintaining the company’s rating at a certain level can also be an explicit goal for management.

As leverage rises, rating agencies tend to lower the ratings of the company’s debt. This is done to reflect the higher credit risk resulting from the increasing leverage. Lower ratings signify higher risk to both equity and debt capital providers, who in turn demand higher returns.

External Factors Affecting Capital Structure

Market Conditions/Business Cycle

A company’s cost of debt is equal to a benchmark risk-free rate plus a credit spread specific to the company. Market conditions/ business cycle affect both the benchmark rates and the credit spreads. The credit spreads tend to widen during recessions and tighten during expansions.

Companies may increase their use of debt when borrowing is less expensive due to low benchmark interest rates and/or tight credit spreads, and vice versa.

Cyclical industries: The revenues and cash flows of companies in cyclical industries (e.g., mining) fluctuate widely with the business cycle. Therefore, such companies tend to use less debt in their capital structure as compared to other companies in less cyclical industries.

Regulatory Constraints

The capital structures of some firms are regulated by government or other regulators. For example, financial institutions are required to maintain certain levels of solvency or capital adequacy, as defined by regulators.

Industry/Peer Firm Leverage

Companies in the same industry tend to have fairly similar capital structures. This is because they are likely to have similar assets and business model characteristics. For example, companies in the automobile industry tend to own large proportions of tangible, non-fungible fixed assets in the form of property, plant, and equipment, with significant proportions of debt in their capital structures.

3. Capital Structure and Company Life Cycle

In this section we will look at the typical changes in a company’s capital structure as it evolves from a start-up, to a growth business, to a mature business.

Background

A company’s life cycle stage influences its cash flow characteristics, its ability to support debt; and is therefore a primary factor in determining capital structure. Any capital that is not sourced through borrowing must come from equity.

As companies mature and move from start-up, through growth, to maturity, their business risk typically declines, and their operating cash flows turn positive and become more predictable. This allows for greater use of leverage at more attractive terms. This is illustrated in Exhibit 7 from the curriculum.

Start-Ups

• In this stage a company’s revenues are close to zero and a lot of investment is required to move from the prototype stage to commercial production.
• Therefore, cash flow is usually negative.
• The risk of business failure is high.
• The company typically raises capital through equity rather than debt.
• Equity is generally sourced through private markets (venture capital) rather than public markets.
• Debt is generally not available or is very expensive. It is usually a negligible component of the capital structure.

Growth Businesses

• In this stage a company typically experiences high revenue growth but investment is needed to achieve this growth.
• Therefore, cash flow may be negative but it is likely to be improving and becoming more predictable.
• The risk of business failure decreases.
• As the business becomes more attractive to lenders, debt financing may be available at reasonable terms. The company may also have assets that it can use to secure debt.
• However, most companies use debt conservatively to retain their operational and financial flexibility.
• Equity is generally the main source of capital.

Mature Businesses

• In this stage a company typically experiences a slowdown in revenue growth; and growth-related investment spending decreases.
• Cash flow is usually positive and predictable.
• The risk of business failure is low.
• Debt financing is available at attractive terms often on an unsecured basis.
• To take advantage of the cheaper debt (as compared to equity) companies typically use significant leverage.
• Over time a company may experience de-leveraging due to continuous positive cash flow generation and share price appreciation.
• To offset this de-leveraging companies typically buy back shares and reduce the proportion of equity in the capital structure.
• Share buy backs are preferred over cash dividends as they are more tax-efficient and do not set future expectations.
• Investors generally respond favorably to share buy back announcement, which may lead to an increase in share price.

Unique Situations

In the preceding sections we established a general relationship between company maturity and capital structure. However, there are two important exceptions:

• Capital intensive businesses with marketable assets: Business such as real estate, utilities, shipping, airline etc. are highly capital intensive. Also, the underlying assets can be bought and sold fairly easily and make for a good collateral. Such businesses tend to use high levels of leverage irrespective of their maturity stage.
• “Capital-light” businesses: Some businesses such as software can scale easily and do not require substantial investments in fixed or working capital to support growth. They are typically cash flow positive from an early stage and never need to raise large amounts of capital. Therefore, they tend to use very little debt in their capital structure.

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