Optimal Capital Structure

WACC (or Weighted Average Cost of Capital) can be used as an investment tool when deciding whether to invest in a given project. If the return on the project is higher than the WACC the company is creating value, if the return is lower than the WACC, the company is shedding value. Organisations apply hurdle rates to projects they consider, this is the minimum rate of return required by an investor or manager on a given project, the higher the risk, the higher the hurdle rate.

The capital structure (or how a company funds its operations and growth) of a business is a critical decision for a company, should the business be funded through debt or through equity? Or what proportion of each? Debt financing usually offers the lowest cost of finance because it is tax deductible however as the company's debt increases, so does the risk.  The optimal capital structure will allow an organisation to maximise its value through an acceptable cost of capital and risk level. A company's debt to equity ratio will provide a picture of how risky the company is.

A company more heavily financed by debt will be more risky. Peacocks has been described as having an 'unsustainable capital structure' (J Pope of KPMG) which lead to their sale out of administration to Edinburgh Wollen Mill in February this year after being unable to secure refunding of £240m of its £750m debt.

During its expansion, Peacocks floated on the stock market but the CEO Richard Kirk was unhappy with the valuation and lead a management buy out with backing from financial institutions including Goldman Sachs. It is this debt which is at the centre of the problem. Peacocks had suffered from tough economic conditions and the banks refused to provide further working capital. In April 2010, the stores appeared to have made a profit of £27m but this was reduced to a pre tax loss of £56m after bank loans and overdrafts.

The relationship between debt and a company's capital structure is complex, it can both increase and decrease a company's WACC because although a higher proportion debt decreases the WACC because its cheaper than equity, it also increases the WACC because shareholders want more returns for a higher level of risk. The question is, can the way a company is financed add more value for shareholders? And if it can, what is an acceptable risk level? Interest and repayments back to lenders won't go away, profits do. If a company doesn't make a profit, it has the option to withhold dividend payments, not so with repayments. Shareholders appreciate a certain level of risk, they respond to it through the market, the question is how much is too much?

The discussion surrounding an optimal capital structure is not a new one. It is widely acknowledged that the balance of gearing has an impact on the overall value of an organisation however, Modigliani and Millar (1958) argue that a company's capital structure has no impact on the WACC and therefore no optimal structure exists because the company is valued on risk alone.  One of the flaws in the argument is the assumption that no taxation exists. That's like saying Santa doesn't exist, it's just not true. Thankfully in 1963 M&M updated their theory to include tax (but not Santa).

It seems to me that compromise is the only option, with a reasonable compromise being the point before shareholders want higher returns because of increased debt and the resulting increased risk.  It's a bit like tightrope walking, one push and you're off!





BBC News website, Arnold