Capital Structure: Perspectives

Introduction

Capital has three forms: human, tangible, and financial. In this article, we focus on how financing choices influence the cost of financial capital and company value. Capital structure focuses on the sources of financial capital. The choice of structure affects firm value in some economies.¹

The seminal works of Nobel laureate Franco Modigliani conceived important relationships and issues in capital structure. Subsequently, researchers have nourished the development of capital structure theory and the related literature, and they have influenced practice. Many companies follow the prescriptions of capital structure theory, and create value for stockholders and society.²

We do not have the “perfect” capital markets described by economists, and key factors influence the choice of capital structure. For example, investors are concerned with the potential for, and cost of, bankruptcy. If a company disappoints investors by using too little or too much debt, its stock price will suffer. Understanding exactly how the use of some debt may add to company value is essential to understanding capital structure.

First, we will clarify the meaning of capital structure. Then we will address other issues.

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Capital Structure

The decision on capital structure is the choice of how to finance a company. Capital structure represents the proportion of each source of financing relative to total financing. Types of financing fall into broad categories: equity, representing ownership; debt; and preferred financing. Interestingly, in some economies the concept of equity or ownership was unfamiliar until recently, as historically individuals did not enjoy the privilege of ownership.

Capital structure is about dividing up expected economic returns (not accounting returns) and risk, in exchange for providing capital. Those divisions are specific. For example, a pecking order exists amongst the different creditors. The “covenants” of debt arrangements, as well as precedent in practice and legal arrangements, address these relationships. For example, in practice “normal” trade credit is often not formalized, and the company routinely pays trade creditors.³

In the context of capital structure and an “ongoing enterprise,” equity ownership is last in line with a claim on what others have not claimed of the returns. Equity holders also bear the risks which the creditors and preferred shareholders (if present) have not accepted. In the event of financial distress or bankruptcy, in most economies very specific rules apply to dividing up the carcass.⁴

In Figure 1, the balance sheet depicts the “assets” and the source of financing, and, consequently, the claim on the assets. For simplicity, we will focus on financing with a combination of debt and equity, ignoring preferred shares as a source of capital. In fact, many firms do not have preferred shares.

Figure 1. Alternative capital structures

The choice of assets, how well we manage the assets, and the nature and success of our providing product/services to markets, taxes, and other factors determine the business risk of the company. The business risk influences the cost of equity capital. For a firm without debt, or an “unlevered” firm, the cost of equity equals the risk-free rate of interest plus a premium for business risk. Collectively, the business risk factors will determine the expected level and risk of cash flows that originate in the asset side of the company. These expected cash flows that come from the asset side of the company must service any debt. After debt service and the payment of taxes, the net remaining cash flows provide the expected returns to equity holders.

The higher the business risk of a company—and hence, the greater the uncertainty in cash flows from the asset side of the business—the less financial risk a company should have, and the lower the optimal D/E ratio.

Consequently, the more uncertain the environment, and the greater the sensitivity of the business side of the company to the economic environment, the more important it is that one select a capital structure with care. Companies with high sensitivity to the cyclical effects of the economy should consider a more conservative capital structure, and have a strategy to manage the structure across economic cycles.

For the purposes of discussion, Figure 1 shows four alternative financing arrangements. In financing alternative A, only equity holders provide capital. In finance jargon, situation A represents an unlevered firm. Each equity holder has a claim on the after-tax benefits of owning and operating the assets, as well as on the assets themselves. The proportion of total shares owned determines the claims of each. In some instances, different classes of equity exist, with the rights of each class defined accordingly.

Alternatives B and C represent different ways of financing the same assets, with C having a higher debt/equity ratio than B. Assuming that the nature of liabilities (discussed shortly) for B and C are the same, C, which has the higher debt/equity ratio, has greater financial risk. We will explain alternative D later in the chapter.

Relative Position and Risk

Capital structure does not involve sharing, but dividing and ordering. Deciding to use debt and/or preferred ownership entails dividing expected returns and risk, and ordering claims—both for “normal” times, as well as in the event of bankruptcy. Think of a line of people, an uncertain future, and expected benefits that may stem from the operation or sale of a company’s assets, or benefits that might arise from the financing of the company.

A metaphor helps in understanding the issues and relationships. Imagine an apple orchard. Uncertainty exists about future crops in terms of the size, and quality, of the apples. Variance in quality means not all apples in a crop have equal value. Let’s see how the ordered line works.

Governments are first in line, taking the most certain and best apples for taxes. Some taxes are ardent claims, which are due independent of the sufficiency of the crop. Equity holders bear this tax responsibility. However, tax circumstances also affect creditors and other providers of capital.

Fundamental Principle: The Division of Risk and Expected Return

A position first in line gives first access to the orchard, and the right to take the best apples. Others enter the orchard according to their order in the line, each taking the apples they are allowed—if apples are available. The average quality of the remaining apples declines with the successive removal of the best of the remaining crop, as those in line are careful and claim the best apples to which they are entitled. Remove the best, and the quality of what remains must be lower—and the risk that insufficient or no apples remain increases.

After the tax authorities, creditors are next in line, with multiple creditors each careful to specify and protect their position in the line. Sometimes creditors limit the number and/or magnitude of other credit claims in line. Preferred stockholders (if the company has any) have a position in line ahead of common stockholders, but behind creditors. A company may have different classes of stockholders, with the classes also ordered.

Equity holders are last in line, expecting to get the lower-quality (higher-risk) apples that are left, and having a claim on all that are left. Equity holders, last in line, have the most risk, but also the possibility of unlimited returns. Equity holders bear the risk that others have not accepted, and they get what is left over. Different classes of equity holders may exist, with these classes differentiated and “labeled,” for example, class A. The classification scheme specifies the positions, potential rights, and claims of each class.

With distress or bankruptcy, the provisions of the various sources of financing specify the relative position and claims of each party, but with one usual modification: tax liabilities, attorneys, and related costs often take first from the carcass. After that, an ordered picking over the corpse follows.

Motivation for Using Debt

A logical question surfaces: why would equity holders allow others to go ahead of them in the line? There are two main reasons for this: garnering incremental value; and/or issues of control.

Increased Value

Potential increases in value stem from “leveraging effects” (stockholders) and tax effects (total firm value). Capital structure theory generally focuses on the value that may originate in tax effects that result from the use of debt. This article focuses on capital structure, but we will first briefly comment on the classic financial leverage reasons for using debt.

Equally Clever Creditors and Stockholders Have Implications

The presence of astute creditors and stockholders will result in no bargains or favors in terms of dividing up expected returns and risks. Creditors will not give stockholders a bargain just to be nice. Absent control issues, capital structure is only important if interest on debt is tax-deductible, and dividend payments are not deductible.

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Tax-Deductible Interest

In some economies, interest is tax-deductible. The expected deductibility of interest payments provides opportunity for value. The expected benefit of this deduction flows to stockholders, which is best illustrated with an example.

Example

A company borrows money at a fixed rate of 10%. The tax rate is 30%. The company expects to have sufficient pretax income to allow the deduction of the interest before calculating taxes. The net effects are:

• Lenders expect payment of 10%, whether the company has taxable income or not.
  
• If the company realizes the tax deduction, the after-tax cost = 10% (1 − 0.3) = 7%.
  
• The expected benefit of the tax deduction goes to stockholders.
  
• The stockholders have increased financial risk that stems from the borrowing—and letting creditors precede them in line.
  
• Stockholders are astute. Increased risk increases the cost of equity capital.
  
• However, if the expected value of the tax savings is attractive to stockholders relative to the added risk of borrowing, stockholders are happy, and the share price increases.
  
• The right choice of capital structure will result in a reduction of the weighted cost of capital—even though the cost of both equity and debt capital increase with debt, as Table 1 illustrates, and we discuss below.
  

Importantly, the tax deduction and its benefit is an expected benefit, as the uncertain pretax income (EBIT or NOI in several economies) must be large enough to allow the interest deduction.

Tax Rate and Implications

Notice that the higher the tax rate, the greater the potential impact of the deductibility of interest on the after-tax cost of debt. For example, with the same 10% borrowing rate but a 40% tax rate, the after-tax cost is 10% (1 − 0.4) = 6%.

We take care not to confuse issues. We don’t benefit from higher tax rates. However, the higher the tax rate we endure, the more important becomes the choice of capital structure.

To reiterate, the tax benefits of using debt do not alter the promised cash flows in the form of interest or principle to creditors. Any tax benefits therefore precipitate to stockholders, and that is core to understanding how capital structure can create value.⁵

Asymmetry of Effects

The use of some debt in place of some equity will lever up (down) the expected returns to stockholders. If interest is tax-deductible, the potential good or bad leveraging effects are asymmetric. If the company has returns on its assets that exceed the cost of debt, a positive leveraging effect accrues to stockholders. If stockholders view these returns as attractive, given the financial risk of the added debt, the stock value increases.

If the EBIT for tax accounting is insufficient to allow the deduction of interest, stockholders must now bear the full cost of debt rather than benefit from a lower after-tax cost.⁶ This shift in tax impact results in a greater and adverse leveraging effect on returns to stockholders, as equity investors must now cover the full cost of debt, rather than the after-tax cost of debt. Using the original example above, the cost of debt rises from the after-tax 7% to the full 10%. The inability to realize the interest deduction results in an asymmetric effect on expected returns to stockholders.

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Behavior of Weighted Cost of Capital

An example showing the behavior of the component costs of capital and the weighted cost of capital (WCOC) appears in Table 1. For simplification, we consider only equity and debt sources of capital. One might employ one or more models, or different forms of models, as well as alternative econometric procedures to estimate the costs of the components of capital for different levels of leverage.⁷

Table 1. Calculation of weighted cost of capital (WCOC)

Source of capital	Relative proportion	Cost of component	Weighted cost of component	Weighted cost of captial
Debt	0%	5.40%	0.00%
Equity	100%	13.00%	13.00%
				13.00%
Debt	10%	5.40%	0.54%
Equity	90%	13.40%	12.10%
				12.64%
Debt	20%	6.10%	1.22%
Equity	80%	13.90%	11.12%
				12.34%
Debt	30%	6.60%	1.98%
Equity	70%	14.50%	10.15%
				12.13%
Debt	40%	7.60%	3.04%
Equity	60%	15.50%	9.30%
				12.34%
Debt	50%	9.00%	4.50%
Equity	50%	17.20%	8.60%
				13.10%

Entries reflect the raising of money from debt and equity in different proportions. The more debt that is used as a proportion of the total, the less equity (and fewer shares). Costs are after-tax costs to the company. The cost of debt represents the weighted cost of debt, reflecting the fact that first-in-line creditors have lower risk, and the borrowing cost is lower. Creditors that follow in line have greater risk, and demand a higher rate. The chapter, “The Weighted Cost of Capital: Perspectives and Applications,” addresses issues related to the WCOC.

For all entries in this table, the company is getting the same amount of money. The values show the effects of getting this money in different proportions from debt and equity, which is the capital structure decision.

Choices of capital structure seek to increase the value of the firm. Hence, in Table 1 and all discussion in this chapter and the chapter, Capital Structure: A Strategy that Makes Sense, debt and equity refer to the market values of debt and equity. Hence, the D/E ratio we calculate uses the market values of the debt and equity.

Note in Table 1 that the weighted cost of capital (WCOC) at first decreases, reaching a minimum when about 30% of capital comes from debt and 70% from equity. Observe also that this decrease occurs even though the weighted cost of debt increases with the use of an increased proportion of debt capital. Recognize that successive increments of debt cost more, as successive creditors in the line of claimants demand higher expected returns to compensate for their higher risk.

With an increase in the use of debt, the cost of equity increases as well. Equity holders recognize the greater financial risk attendant with a higher D/E ratio, and demand increased expected returns.

Seemingly, the WCOC could not decline if the cost of components increased. The reason for the decline stems entirely from the expected tax-deductibility of debt, and equity holders think the value of the tax benefit is attractive compared to the added risk. As the D/E ratio increases, the amount of equity decreases because we are raising the same amount of capital everywhere in Table 1. If we raise more from debt, less comes from equity. The use of some debt rather than all equity amplifies the effect on a per-share basis, as the company needs fewer shares for the same amount of capital. The result is that with an increasing D/E the expected tax benefits increase, and these are spread over fewer shares.

In the example in Table 1, note that obtaining more than 30% of capital from debt results in an increase in the WCOC. Above 30% debt, stockholders do not think that the incremental tax benefits of more debt are attractive enough to compensate them for the incremental financial risk, and the uncertainty of realizing the tax benefits. Hence, the demanded rate of increase in the cost of equity and debt overpowers the effects on value of the expected incremental tax benefits of employing more debt.

Summary

Given a particular business risk of a company, determined by the asset side of the business and how well the company employs its assets, an optimal capital structure exists—optimal, as it lowers the WCOC of the company. For example, in Table 1, using about 30% from debt and 70% from equity will result in the lowest weighted cost of capital.⁸ Note in the table that the cost of components increases in a nonlinear manner as the use of debt increases. This behavior is related to several factors, including: the risk of realizing the expected tax benefit of debt; potential distress caused by excess debt, and its effects on operations as well as opportunities and investments; and possible bankruptcy with attendant loss.

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Other Issues

The Nature of Liabilities and Optimal D/E

The nature of the liabilities influences the choice of capital structure. Let alternative D in Figure 1 represent the same capital structure as in alternative C. Suppose that certain characteristics of the liabilities for C and D differ. To illustrate, assume that the weighted maturity of liabilities in D is less than that in C, and/or that C represents borrowing at a fixed rate while some debt in D has a variable rate of interest.

Despite the same D/E ratio, the financial risk of D is greater than that of C because D is bearing interest-rate risk if the debt has a variable rate of interest, and D has more risk as it faces refunding of debt sooner. Less flexibility in the timing of refunding the debt is a potentially important issue, as capital market conditions vary over time. The developments and difficulty for firms of obtaining “replacement” credit in the 2008 crisis illustrate this refunding risk.

Logically, the nature of the liabilities therefore affects the optimal D/E ratio. For A, B, C, and D, the business risk is still the same. The use of liabilities with greater risk (in this scenario, maturity and interest rate risk) results in a lower optimal D/E, despite the same business risk on the asset side of the company. Thus, if the structure shown for C is optimal, the structure shown for D is incorrect. D should have a lower optimal D/E ratio than C, as the nature and structure of liabilities for D results in higher risk on the financing side of the company.

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Conclusion

The tax deductibility of interest provides the opportunity to add to company value by employing the correct amount of debt relative to equity. The underlying relationships that cause this potential increment in value rest on the logical behavior of informed investors who agree to divide risks and expected returns. The deductibility of interest has expected economic benefits that flow to equity holders. Consequently, the use of debt is logical if interest is tax deductible and we expect to realize the benefit of that deduction. The higher the corporate tax rate we must endure, the greater the value of issuing debt.

The choice of how to finance the company, and its resulting debt/equity ratio, is the capital structure decision. Issues relating to the strategy and management of capital structure are discussed in the article, Capital Structure: A Strategy that Makes Sense.

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Making It Happen

• Remember that the expected tax deductibility of interest is the origin of any value that arises from the choice of capital structure.
  
• In capital structure decisions, the examination focuses on the market value of debt and equity.
  
• Changes in the tax rate will influence the optimal capital structure.
  
• The greater the business risk, the lower the optimal D/E ratio.
  
• The choice of capital structure will influence the cost of the individual sources of capital, and, in turn, the weighted cost of capital.
  
• “Real world” considerations argue for a target capital structure, and a strategy to pursue that structure. The chapter, “Capital Structure: A Strategy that Makes Sense,” examines these issues and offers guidance on a strategy.
  

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Notes

¹ Issues of control can influence choice of capital structure, for example, with current managers not willing to issue equity as the issuance would dilute management’s “personal” control percentage, or alter the distribution of shares in float.

² Actions that lower the cost of capital result in benefits to individuals in economies and societies. In contrast, in 2008 we have witnessed the adverse and spreading effects that result from interruptions in the availability and/or cost of capital in economies.

³ If suppliers perceive unnecessary risk or the likelihood of financial distress, suppliers may demand trade notes payable. Trade notes payable formalize trade credit, and seek to clearly identify the obligation. Hence, requiring formalization of obligation with trade notes payable clarifies as well as “perfects” the supplier’s interest, and relative claimant position. This formalization can alter the risks to the suppliers of receipt of payment, both during ongoing operations as well as in the case of bankruptcy. Normally, the existence of trade notes payable on a balance sheet signals concerns by trade creditors of the financial viability of the company.

⁴ Multiple classes of equity may exist, with specified relative claimant positions during normal operations as well as in bankruptcy.

⁵ In imperfect markets with multiple periods, and with certain tax rules, the risk of promised cash flows to creditors may be reduced by the tax-deductibility of interest in previous periods or by carry-back tax effects. These issues are beyond the scope of this article.

⁶ In some environments, differences exist in accounting for taxes, and accounting for financial reporting.

⁷ The most common approaches include several different model forms based on the capital asset pricing model, multi-factor models, discounted cash flow models, risk-premium models, and other pricing models.

⁸ This is an approximation. Estimating the WCOC curve and finding the minimum point is not a precise science.