Capital Structure

Discussed previously has been how companies can raise finance through either debt or equity. However, this blog goes into more detail discussing the capital structure of a company. It is generally well known that that the cost of equity is usually higher than the cost associated with debt. Financing through equity requires higher returns than activities which are financed debt. However, is it really viable for a company to load up on debt because once debt exceeds a certain level its benefits become unapparent?

The question is why is debt finance cheaper? One of the key reasons is because lenders usually require a lower rate of return than ordinary shareholders. In addition to this debt interest is not included in the corporation tax bill thus reducing the amount of tax paid. Therefore companies should increase their gearing level as this would mean the cost of financing their company will reduce. The general aim of gearing is to increase shareholder wealth. However, there comes a point when companies finance too much through debt and problems can arise. After all companies have to pay interest on their debt and need to meet their payments no matter how well the company may be doing.

Explained in a previous blog was the concept of Weighted Average Cost of Capital (WACC). Having more debt can reduce the WACC because debt is cheaper than equity however, having more debt can also increase WACC due to the fact equity holders want more returns. How companies structure their capital will ultimately determine their WACC and more importantly what projects they can undertake to return value back to shareholders. The important thing is that they get it right.

Changing the capital structure of a company can increase both the value of a company and increase the level of shareholder value. However, gearing can also increase the risk to shareholders. Companies which have a high level of gearing are generally perceived as high risk. The diagram below shows how increasing the level of gearing can increase the financial risk to a business.

A previous blog talked about the impact of the credit crunch and how it is still affecting today’s economic environment. Sources of cheap debt were available therefore, it seemed sensible for companies to load up on debt. It was cheaper than sourcing finance through equity and the low interest rates meant there was little risk involved. However, interest rates rose and the risk of companies faltering on their repayments became frequently more apparent.

Governments, banks and major companies have all gone kaput because they loaded up on too much debt. When companies think about their capital structure they often only think about the short term consequences. A recent example of a company loading up on too much debt is the retailer Peacocks. Back in January the company entered into administration having tried unsuccessfully to restructure its £240m debts. The company has recently been bought out by Edinburgh Woollen Mill; the deal will save around 6000 jobs. However, unfortunately the deal means 224 stores will be forced to close in the UK leading to 3100 redundancies.   

The problem companies’ face regarding their capital structure is a challenging one. While sourcing through debt finance can reduce the WACC and make more projects worthwhile it can also drastically increase the risk of a company. Companies not only have the responsibility to shareholders but to their employees as well. 3100 people are out of a job due to Peacock’s inability to impose a sustainable capital structure, how many more job losses will we see in the future?

Sources Used: bbc.co.uk, Multinational Finance (Mffett et al. 2009), Northumbria university eLearning portal.