Ideal Capital Structure– Predominate Theories; Pecking Order, Trade-Off, Market Timing: Seeking a Golden Rule…

What’s the optimal capital structure for a company? Capital structure is how a company finances its overall operations and growth by using various sources of funds– It’s mix of different types of– debt, equity, and profit. If your company hasn’t given this question serious thought, than it’s about time that it did…

Broadly speaking there are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure in terms of payoff for shareholders; risk/reward. The crucial issue for deciding the right capital structure is to identify the best combination of equity and debt that maximizes the market value of the company and minimizes the cost of capital. The three most prominent theories of capital structure are;

  • Pecking Order Theory: It postulates that the cost of financing increases with asymmetric information. Financing comes from three sources and companies prioritize their sources of financing by orderly selection (the pecking order); first, internal funds, than debt, last equity…
  • Trade-Off Theory: It refers to the idea that a company chooses how much debt and equity finance to use by balancing (trade-off) the costs and benefits…
  • Market Timing Theory: It decides how to finance with equity or with debt instruments based on the timing of market conditions…

Modern theories of capital structure began with the proposition of Modigliani and Miller (1958) that described the conditions of capital structure relevance… Since then many economists have changed their financial models in order to explain the key factors driving capital structure decisions.

According to Anton Miglo; the recent financial crisis has forced many companies to look critically at various modern capital structure theories… However, the problems of many companies is related to their flawed financing policies and lack of a clear understanding of the role of asymmetric information and agency issues– i.e.; conflict of interest between two involved parties, e.g.; management vs. shareholders, or bond issuers vs. investors… 

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Assessing the overall capital structure situation is interesting, for example: The Trade-Off Theory can explain a lot of factors about capital structure, except for one weakness, which is the negative correlation between debt and profitability… The only theory which provides a straight explanation for this phenomenon is the Pecking-Order Theory; although it has other issues…

According to Li-Ju Chen, Shun-Yu Chen, Chang; recent studies have shown a focus shift from the Trade-Off Theory to Pecking Order Theory… The Pecking Order Theory was popularized by Myers and Majluf, and it assumes that there is no specific target capital structure… companies choose their need for capital based on the following preference (or pecking order); internal finance, debt, equity…

Also, Myers and Majluf argued that ‘equity’ is the least preferred way to raise capital due to the role of asymmetric information– i.e., management know more about true condition of the firm than do investors; hence,  when issuing equity the investors may believe that management thinks that the firm is overvalued and they are taking advantage of this over-valuation.  As a result, investors will place a lower value on the equity issuance…

According to ablogaboutfinance; there is conflicting evidence on the nature of the Pecking Order Theory, e.g.; it performs poorly for small firms because they have low debt capacities that can quickly be exhausted, and forcing them to issue equity. The Pecking Order Theory performs much better for large firms, firms with rated debt, and where the impact of debt capacity is greater…

Overall, the debate over capital structure is unlikely to be resolved in terms of predominance of one prevailing over the others, and since there are a larger number of elements that must be factored, for example; the cost of capital must be balanced against considerations of flexibility… hence, the existence of multiple theories for capital structure provide alternative approaches for the conflicting issues…

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While the Pecking Order Theory argues that companies do tend to manage financing using the easiest approach, for them, as their first choice– this does not necessarily imply that one mode of financing is inherently superior to the others… For example; depending on the circumstances of a business, it may be more prudent to use an asset to acquire a secured loan rather than deplete a business’ interest-bearing accounts…

Also, management must weigh all the options, and then choose the one that is most likely to produce the result that is in the best interests of the company over the long-term, rather than simply going with what appears to be the easiest solution. There is no simple answers for capital structure decisions, in some cases– debt may be better than equity, whereas in other cases it may be worse… In a financial evaluation there are at least four dimensions that must be considered:

  • Taxes: How valuable are interest on debt tax shields? Is the firm likely to pay taxes over full life of a debt issue? Profitable firms are most likely to stay in a debt tax-paying position…
  • Risk: Financial distress is costly even if the firm survives it. Other things being equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt…
  • Asset type: If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets… Such firms generally borrow less than firms with safe, tangible assets…
  • Financial slack: How much is enough? More slack makes it easy to finance investments, but it also weaken management incentives… More debt, therefore less slack…

In the article Determining Ideal Capital Structure by Philip J. Isom writes: In today’s business uncertain climate, it’s critical for most companies to optimize their capital structure and make sure that they retain access to capital. The challenge is to create a structure that is workable through multiple business cycles, and determining an optimal capital structure is an important step… In the simplest terms, a company’s debt capacity comes down to its ability to repay debt and to support ongoing working capital. However, as the past few years have demonstrated, it’s not always simple to predict cash flows, especially in a volatile economic climate…

A company must have a comprehensive understanding of its financial position before it can determine what its capital structure should look like. It’s common for two companies in the same industry to have identical debt-to-equity ratios, but significantly different cash flow capabilities due to different growth rate, cost structure, profitability and asset turnover.

Further, more volatile and uncertain in company cash flows, the more uncertainty there is regarding its ability to meet debt payment obligations. Companies with extremely unpredictable cash flows should usually assume that less debt is more advisable… Thus, an ideal capital structure will not only limit risk of default, but substantially increase profit, shareholder return… In order to make the right decisions, companies must fully understand their specific macro- and micro-economic risks that can affect their business and their industries…

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The appropriate capital structure is critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision has on an organization’s ability to deal with its competitive environment…

According to  Roy L. Simerly and Mingfang Li; researchers have not yet found the optimal capital structure… The best that academics and practitioners have been able to achieve are prescriptions that satisfies short-term goals, for example, in a recent Harvard Business Review article; readers were left with impression that the use of leverage, debt, was one way to improve the performance of an organization.

While this is true in some circumstances, it fails to consider either the complexities of the competitive environment, or the long-term survival needs of the organization… Others argue that the use of leverage, either to discipline management or to achieve economic gain is the ‘easy way out’… and, in many instances, this can lead to the demise of the organization…

So: What is an optimal mix of debt and equity that will maximize shareholder wealth? Or, is this an incorrect framing of the question… Possibly, a better framing might ask the question: Under what circumstances should leverage, debt, be used to maximize shareholder wealth? Debt and equity have profound long-term implications for corporate governance that far exceed exigencies of the moment… One of the dramatic changes created by expanding global economy is the increase in the rate of change within industries… and, as more industries experience greater levels of change, the use of debt-centered governance should prove to be less effective in the near future…

The first duty of management is to ensure the long-term survival of the organization in its competitive environment. In a world devoted to quick fixes and short-term thinking, edited by sound bites, it’s difficult to take time to think through all the serious challenges. But, as business become more competitive, those who make the time to reach appropriate decisions will be the ones left standing… But, there are no easy fixes… there are no hard and fast golden rules in deciding on which capital structure works best…

Capital structure differs from company to company and each company must consider the specific factors that impact their company, for example; how much free cash flow the company is generating, what leverage is it creating, how much interest must it pay, how much interest can it pay, how much revenue is it able to generate… and is the company’s current capital structure yielding the– ideal or desired or optimum benefits… and what are the other alternatives…