Tuesday, 30 May 2017

Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

  1. how much to invest,
  2. how much debt to have, and 
  3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

  1. using equity,
  2. straight debt,
  3. convertibles and
  4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.

Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.

Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

  • are a useful summary indicator of capital structure health and 
  • are a means of communicating information to shareholders.

The two main determinants of credit ratings are

  • size and 
  • interest coverage.

Two important coverage ratios are

  • the EBITA to interest ratio and 
  • the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.

Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

  • the costs of the choices and 
  • the possible signals the choices send to investors.

Methods to manage capital structure include

  • changing the dividends, 
  • issuing and buying back equity, and
  • issuing and paying off debt

When designing a long-term capital structure, the firm should

  • project surpluses and deficits, 
  • develop a target capital structure, and 
  • decide on tactical measures.  

The tactical, short-term tools include

  • changing the dividend,
  • repurchasing shares, and 
  • paying an extraordinary dividend.

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