Appendix 3 - What is the Optimal Capital Structure for Companies?

Finding the right balance between debt and equity can be problematic for a company. Choosing debt is seen as a safer option, as lenders offer large amounts of finance for a relatively small return. On the other hand, equity is more expensive and viewed as the riskier option. Because of this increased risk, shareholders demand higher returns and reduce the owner’s control of the business. Dividends are tax deductible whereas debt isn’t, this suggest that companies should take on more debt in order to increase gearing. Increased gearing will reduce the WACC which would then increase the overall value of the company.

At this point it would seem a straight forward decision; debt is the much safer choice than equity. You only have to repay the loan plus interest, which can be offset against pre-tax profits before the calculation of the corporation tax bill, therefore lowering the amount of tax paid. Whereas with equity, shareholders own part of the company and therefore they will also receive part of any future profits. Raising capital through equity is also costly due to the transaction costs implemented on the stock market.

You are probably thinking why do companies opt to raise capital through equity rather than debt? Well, equity doesn’t have to be repaid and of course, debt does with additional interest. If a business is losing money, they are still faced with the loan repayments but it wouldn’t have to pay any dividends out to its shareholders. A highly geared company will have higher risks of financial distress as a result. Furthermore if a business already has high levels of debts, then it would not be an attractive proposition for lenders to lend even more money. The company may be seen as high risk, which could also have a negative impact on the company’s overall value.

An example of a company who struggled with their capital structure was American Apparel. According to reports in the Financial Times, the company has recently filed for chapter 11 bankruptcy whilst they seek to restructure its debt. American Apparel’s debt rose to 11.6 times its annual earnings and consequently their credit rating has fallen deeper into junk territory of Caa3. A plan has been outlined with creditors to swap $200m in debt for equity which shows they did not have the right balance of debt and equity. This restructure will help to reduce interest payments by $20m which shows how damaging debts can be.

Modigliani and Millar argued in 1958 that a company’s structure does not have an impact on the WACC, therefore no optimal structure exists and the value of a company was dependent on business risk alone. This theory assumed that capital markets were perfect, with no tax, no transaction costs, there was no financial distress and that individuals could borrow as cheaply as corporations. In reality, could this theory work? When comparing these assumptions to real world business, the theory can be easily argued against. M&M’s theory in 1963 incorporated these assumptions and suggested that as you increase gearing you will reduce the WACC, which will then increase the company’s value.

Having studied capital structures, personally I believe funding a company simply through debt is a bad idea. Although it does have its benefits, debt still has to be repaid regardless of how well the company is performing. The level of debt a company has should be suitable for the industry and at the same time, be accepted by the shareholders in order to increase value. The balance between debt and equity will vary depending on the industry a company operates in, however I believe that equity and other ways of financing should definitely be used.