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:
- how much to invest,
- how much debt to have, and
- how much cash to return to shareholders.
Choices concerning capital structure
Managers have many choices concerning capital structure, for example,
- using equity,
- straight debt,
- convertibles and
- 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.
- 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.