Chapter 35
CAPITAL STRUCTURE POLICIES : Working out details: The design of the capital structure

Whereas frequent disequilibria in industrial markets engender the hope of creating value through judicious investment, the same cannot be said of choosing a source of financing. Financial markets are typically close to equilibrium, and all sources of financing have the same cost to the company given their risk.

The cost of financing to buy an asset is equal to the rate of return required on that asset, regardless of whether the financing is debt or equity and regardless of the nationality of the investor.

It follows that the choice of source of financing is not made on the basis of its cost (since all sources have the same risk-adjusted cost!). Apparent cost must not be confused with financial cost (the true economic cost of a source of financing). The difference between apparent cost and financial cost is low for debt; it is attributable to the possibility of changes in the debt ratio and default risk. The difference is greater for equity owing to growth prospects; greater still for internal financing, where the explicit cost is nil; and difficult to evaluate for all hybrid securities. Lastly, a source of financing is cheap only if, for whatever reason, it has brought in more than its market value.

Because there is no optimal capital structure, the choice between debt and equity will depend on a number of considerations:

The reader who performs simulations of the principal financial parameters, differentiating according to whether the company is using debt or equity financing, should be fully aware that such simulations mainly show the consequences of financial leverage:

affecting liquidity in a way that varies with the term of the debt.