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


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 it has brought in more than its market value (inefficient markets).

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

  • Macroeconomic conditions. High real (inflation-adjusted) interest rates and low activity growth will prompt companies to deleverage. Inversely, rapid growth and/or low real interest rates will favour borrowing.
  • The desire to retain a degree of financial flexibility so that any investment opportunities can be quickly seized. To this end, equity financing is preferred because it creates additional borrowing capacity and does not compromise future choices. Inversely, if current borrowing capacity is used up, the only source of financing left is equity; its availability depends on financial markets holding up, which is never certain.
  • The maturity of the industry and the capital structure of competitors. A start-up will get no financing but equity because of its high specific risk, whereas an established company with sizeable free cash flow but little prospect of growth will be able to finance itself largely by borrowing. Companies in the same business sector often mimic each other (what matters is to be no more foolish than the next guy!).
  • Shareholder preferences. Some will favour borrowing so as not to be diluted by a capital increase in which they cannot afford to participate. Others will favour equity so as not to increase their risk. It is all a question of risk aversion, financial capacity of shareholders and extent of control.
  • Financing opportunities. These are, by definition, unpredictable, and it is hard to con- struct a rigorous financing policy around them. When they occur, they make it possible to raise funds at less than the normal cost – but at the expense of the investors who have deluded themselves.

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:

  • raising the breakeven point;

  • accelerating EPS growth;

  • increasing the rate of return on book equity;

  • degrading solvency;

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