How To Optimize Capital Structure

The Second Principle: Optimizing Capital Structure

The next breakthrough happened in 1958. The typical corporation gets money by borrowing it and by selling shares. Different corporations use these two sources of financing, debt and equity, in different proportions. The old rule of thumb was that companies with stable cash flow could rely more on debt financing, and companies that were more cyclical had to use less debt financing and rely more on funds from shareholders. There was no satisfactory proof of this rule of thumb, besides the experience of the marketplace. Two writers, Modigliani and Miller, sought to understand why companies choose to obtain capital from these two sources in specific proportions. They observed that companies appear to have an ideal mix of debt and equity financing in mind. The mix of debt and equity financing is called capital structure, and when a company sets a target for its mix of debt and equity financing, finance experts say it is making a capital structure decision.

To probe the underlying rationale for choosing debt or equity financing, Modigliani and Miller used a method of analysis that in mathematics is called proof by contradiction. They started by asking whether it makes any difference whether the company uses debt financing or equity financing. They asserted, as a way of challenging the old rule of thumb, that companies would not be worth any more or any less if they were financed 100 percent with debt or 100 percent with stockholders’ equity. Then they began testing this bold assertion to see whether it is true or false.

Their initial assertion triggered a healthy debate among finance experts, and by 1962 a much deeper understanding of the capital structure decision had emerged. The debate revealed that capital structure does matter – a company can be worth more if it uses debt and equity financing in the appropriate proportions. The debate also revealed that if a company is using too much equity financing, it can raise its stock price by borrowing money and then using the money to buy back some of its shares in the open market. This maneuver changes its capital structure and raises its ratio of debt to equity financing. Many companies have done this, and the maneuver is now called a common stock buyback.

Many seasoned executives were skeptical of this maneuver. They did not see why the company should be worth more after it alters its mix of debt and equity financing. They thought the company’s stock price went up only because the company was buying its own shares. Some of them believed the maneuver was a manipulation and denied that it creates real value. As the debate among experts continued, however, these executives finally had to admit that capital structure does make a difference. There are many ways of understanding why optimizing a company’s capital structure creates value. All of these ways rest on a premise that needs to be stated clearly at the beginning. The premise is that investors are not buying the whole company; they are buying only small amounts of its stock or bonds. If an investor is buying the whole company, its value depends on how the company will fit with the investor’s other businesses and operations. An investor who is buying only a small amount of the company’s stock or bonds thinks of different issues. If the investor is buying the company’s bonds, he or she judges how risky the bonds are and tries to assess whether the projected yield is high enough to compensate for the risk. If the investor is thinking of buying the company’s common stock, he or she judges how risky the stock is by itself and how risky it will be in his or her portfolio. Once this premise is stated, the assertion that a company’s capital structure affects its value sounds more reasonable. Once everyone agrees that the entire company is not for sale, and that it is a going concern, then everyone agrees the company will raise new funds from time to time. The buyers will be passive portfolio investors, who will not try to exercise control over the company, and who will only put the securities in their portfolios.

Then it makes sense to talk about how many bonds the company should try to sell during a given time interval, relative to the amount of stock it has outstanding. The company finances itself by offering two classes of securities: bonds targeted to risk- averse investors and common stock targeted to risk-tolerant investors. It puts out amounts of each type according to the demand. If it tries to put out too many bonds, investors will refuse to buy or will demand a higher coupon rate. If it puts out too much stock, the market price of the stock will decline.

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