Question

In the current ‘real-world’ setting, explain how capital structure can maximise shareholder value.

Answer 1

Capital structure can maximise shareholder value.

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to use debt or equity to finance operations, and managers will balance the two to find the optimal capital structure.

The capital structure of a company is how it finances its activities - usually through a combination of both debt and equity. Last week it was announced that Norwegian oil producer, Det Norske Oljeselskap ASA (Det Norske), was reviewing their funding options in order to create the optimal capital structure to increase the cash flow it needs for new projects whilst doing this at the lowest cost to shareholders (Bloomberg, 2015). Hersvik, CEO of Det Norske, has noted that the company is able to raise more debt and may also issue more shares - but how should they decide the proportion of debt and equity? Does an optimal capital structure exist? And can this increase shareholder wealth?

The weighted average cost of capital (WACC) is a way of calculating the costs of a company’s capital sources, both debt and equity, which determines the lowest rate of return needed on an investment to satisfy investors (Reilly & Wecker, 1973). This allows a company to determine which investments they can afford and therefore defines the company’s strategic option set as it acts as a hurdle rate for investment appraisal. As a result companies generally seek a low WACC (Watson & Head, 2013), allowing them to pursue more projects which maximise shareholder wealth. The recent oil price crash has reduced Det Norske's cash flows which are needed as they are wanting to take on new projects. By reducing the WACC it will allow the company to invest in these new projects as the company will require a lower rate of return. At first glance, you may think the decision is easy for Det Norske - increase debt as it is cheaper than equity, therefore lowers the WACC thus increasing their scope of possible investments which could increase shareholder wealth.

Decision made?! Not quite.

Whilst increasing debt does decrease the WACC as it is a cheaper source of finance, the traditional view of capital structure suggests that there becomes a point where a company can have too much debt. After this point it starts to become more costly, thus suggesting there is an optimal capital structure (Brusov et al, 2011). Essentially, debt finance is cheaper as lenders require a lower rate of return in comparison to ordinary shareholders. This is because, due to uncertainties and no guarantee of receiving dividends or capital gains, they often demand a higher return to compensate for the risks they are taking, thus increasing the cost of equity. Furthermore the transaction costs associated with raising debt are generally less than those involved in issuing shares and paying dividends and debt interest can be offset with pre-tax profits - reducing the overall tax bill for a company. However the traditional view suggests that there becomes a point where the cost of equity will start to increase as shareholders demand higher returns for the risks they are taking as highly geared companies are seen as risky investments. So it is at this point where a company achieves their optimal capital structure - before the level of debt causes the cost of equity to rise. I take the view that up until this point it seems logical to take on more debt as it is cheaper. However after this point, if a company continues to take on more debt the risk of financial distress increases along with the possibility of liquidation (this concept is summarised in Figure 1). As a result the WACC will increase thus reducing company value and shareholder wealth. Therefore if a company is above or below the optimal level, they are destroying shareholder value. It appears that Hersvik supports this traditional view as he clearly suggests there is an optimal capital structure and he is aiming to achieve it.

To conclude, I personally believe that an optimal capital structure does exist as it seems logical that there becomes a point where having too much debt causes the cost of equity to increase as shareholders become worried. I also believe that when a company achieves such a structure it will increase shareholder wealth as they are able to broaden their strategic option set, thus increasing their scope for investments. In addition, I take the view that there is no generic ideal combination of the structure but that this varies depending on the company, the industry and the economic climate. It is impossible for me to predict what decisions Det Norske will make in terms of their capital structure but I think it is crucial they consider the benefits and drawbacks of both equity and debt finance as well as the business risks they are currently facing and how shareholders will react to the decisions they make. It will be interesting to see what decisions they make and whether they believe they were able to achieve their optimal capital structure.