Written by Carl R.
The capital structure of a company is one of the key decision-making points along with investment decisions and distribution decisions. The capital structure shows how much financial leverage a company has on its books in relation to other capital such as equity. Potential investors look at the capital structure and identify the amount of debt raised by the company and this helps them to assess the risk of financial distress. A high risk of financial distress is associated with bankruptcy. Yet, having too little debt on the books can prevent the company from keeping up with the industry growth rates. Therefore, it is important to understand the key elements of the capital structure and its influence on company value (Chowdhury and Chowdhury, 2010).
Importance of Capital Structure
The capital structure of a firm is essentially the distribution of debt and equity that form part of its total capital. In order to value a company, one of the first few criteria is to estimate the amount of leverage on its books as it helps to assess the cost of capital (Bradley et al., 1984). There has been an ongoing debate as to what is the optimal capital structure for a firm. There can be various combinations of debt and equity in the capital structure. Each combination can lead to a change in the company valuation. Although there have been studies that suggested the irrelevance of capital structure (Modigliani and Miller, 1958), it is widely accepted that the capital structure plays a critical role in company valuation when realistic assumptions are used (Abor, 2005).
There are various prominent theories on the topic of capital structure. The Pecking Order Theory states that companies have a preference to raise debt before raising fresh equity since the costs of debt are lower (Myers, 1984). On the other hand, the Trade-Off Theory states that debt is good for a company’s capital structure up to an extent. The primary benefit of debt on the books of a company comes in the form of a tax shield since interest payments are made with pre-tax money. Secondly, debt can often be a cheaper alternative to equity. Often, the rate of return demanded by equity holders is higher than the annual interest rate paid on debt. In such cases, it is good to have a certain proportion of debt in the capital structure. Accordingly, the presence of debt in the capital structure can result in a higher valuation for the company (Leary and Roberts, 2010). However, as the proportion of debt rises in the capital structure, the costs and risks of financial distress increase. Therefore, a low debt capital structure can be perceived as an indicator that the company is a safer investment. Therefore, capital structure decisions can define the actual valuation of a company (Antwi et al., 2012). Additionally, the capital structure can have a major impact on the value of a firm by affecting both the cost of capital and future cash flows. If the debt is kept to a moderate level, this ensures that the financing costs for the company remain low. Hence, the cost of capital will be low. This, in turn, results in improved performance of the company in terms of net present value (NPV) of future cash flows. At the same time, if the company does not have too much debt, there will be slower outflow of cash in the form of interest payments. Hence, more earnings will be retained (Chinaemerem and Anthony, 2012). The value of a firm is directly related to the expected cash flows and inversely related to the cost of capital. Thus, a moderate level of debt in the total financing mix is often viewed as the optimal capital structure when the benefits of debt are utilised while not allowing for the risk of financial distress to go up significantly (Myers, 2001).
It is valid to note that the Modigliani and Miller (1958) theory states that the company value does not depend on the capital structure if all other external factors are constant. However, this theory is based on unrealistic assumptions such as the absence of taxes, agency costs, and bankruptcy costs. Financial distress can lead to legal and other bankruptcy costs, which can be a potential hurdle. Therefore, the lesser the amount of leverage on the books, the better it is for the firm value. However, if the company enjoys a rate of return on new investments in excess of the cost of debt, the new debt will improve return on equity (ROE) and value of the company. Nevertheless, it has been noted in empirical studies that firms with less debt tend to perform better when it comes to profitability (Jouida, 2018).
Additionally, there is another argument that the capital structure can have other forms of indirect bearing on a firm’s valuation. For example, the capital structure of a company is noted to have an effect on the agency costs and firm investment strategy. If the company uses external debt financing to make new investments, the top management will be more prudent in their strategic investments and capital expenditure as inability to repay debts will hurt both the shareholders and managers. At the same time, if bad investments are financed with equity, mostly shareholders will lose (O'Brien, 2003). A firm’s tax structure is also important when it comes to its overall valuation. The firms which focus on maximising the benefits of tax shields by raising debt often do not consider the risk involved with being highly leveraged. This, in turn, leads to a capital structure which is riskier. Such firms suffer in terms of their valuation, thereby implying that the capital structure can impact the value (Masulis, 1983). Additionally, being highly leveraged reduces the flexibility of the company and increases both the cost of issuing new debt and the cost of equity at the moment (King and Santor, 2008).
Thus, it can be concluded that the capital structure of a firm has a direct impact on its value. This happens by means of direct factors such as the cost of capital and future cash flows, as well as indirect factors such as strategy, decision making, agency costs and tax structure. Since debt is found to have both positive and negative features, it can be summarised that companies which manage to keep debt levels to a moderate level are more likely to have a better valuation and thus become more attractive to potential investors.
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