Capital structure

Externally raised capital may be debt or equity, although hybrid structures can also be created. Capital-structuring theory and market practice provide many techniques for optimizing an organization’s capital structure.

An organization’s financial strategy assesses the optimal financing solution, based on the following three factors:

  1. Ranking of capital – the ease and cost of financing
  2. Leverage – how to measure and monitor leverage
  3. Markets – the diversity of sources and the maturity of financing.
Gearing or leverage

The proportion of total capital that is debt is called 'gearing' or 'leverage'. The optimum level depends on the organization's risk and return dynamics. Higher levels of debt increase the required return on equity (the cost of equity to the organization), which is classically offset by the increased amount of the relatively cheaper debt.

By maintaining a gearing or credit-rating target, an organization is able to position its creditworthiness in the funding markets, optimizing sources, pricing and terms for funding.

Considerations for some organizations may be the tax treatment of loan interest, equity dividends, and (under the G20 Base Erosion and Profit Shifting [BEPS] proposals) the amounts and locations of debt.

As shown in Figure 2, the overall cost of funding – the weighted average cost of capital – increases with higher gearing (as well as with the riskiness of the business strategy). At some point, investors are likely to become concerned about return of capital (not return on capital): in such cases, new funds are refused whatever the price offered. In squeezes and panics, such a refusal may arise at much lower gearing levels, leaving some organizations that were previously financeable now incapable of finding finance.

Figure 2: Gearing levels
(Curves are intended to illustrate the concept and do not represent costs for any particular company)

Gearing levels

Figure 3: The effects of gearing/leverage

The effects of gearing/leverage

If the return on assets is unchanged, businesses might find the effects shown above when moving from stronger credit (less debt) to weaker credit (more debt).

Corporate borrowing

Riskier businesses or those with shorter-lived assets will tend to rely more on equity and only borrow over the short term if at all (perhaps for a quarter or a year).

Organizations with more stable cash flows and longer-term assets will be more comfortable servicing debt and so are likely to borrow for proportionately longer periods. For example, a building may be 65% debt-financed, out to 30 years, with the (supposedly) reliable rental income servicing both the debt and equity.

Some loss of control by shareholders can be a non-cash cost of debt. This is because covenants in lending contracts can cause constraints meaning that lenders can ultimately take control.

This loss of control may be too risky for some organizations, so they choose to avoid debt. Examples include businesses like high-tech, nano-tech or bio-tech companies with high real-option values that are dependent on further development being undertaken by hard-to-find experts.

Other organizations deliberately choose a high gearing strategy, such as the use of structured finance, hybrid instruments, project finance or private-equity deals.

The availability of funding cannot always be relied upon, as banks’ risk appetites vary depending on market conditions. This can impact the industries, credit standings and even the geographical regions to which banks are willing to lend. Organizations will therefore need to plan the raising of new funds well ahead of when they need them, to diversify their sources of funding and to ‘warm up’ potential investors and lenders in advance. Few organizations that have the ability to choose would leave the refinancing of significant committed outlays or debt maturities to the final 18 months before the requirement crystallizes.

Table 1: Main funding types and their characteristics

The effects of gearing/leverage
Asset-based finance

Some assets lend themselves to dedicated finance, often called ‘asset-based finance’, while some items can be leased instead of owned. Some assets, such as land and buildings or expensive equipment, are good security for a provider of acquisition funds. On the working capital front, supplier-led invoice discounting or factoring (the sale of receivables) and ‘supply-chain finance’ (where the buyer leads the process) can all be useful. But it must be noted that the more asset-based finance an organization uses, the less asset value remains to support credit taken from other lenders, trade creditors and employees for unpaid salaries. This can change the attitude of those creditors.

An old saying, ‘fund early and fund long’, remains true. Organizations need to work harder than ever on their funding relationships – not just bank relationships, but all the increasingly diverse potential sources of funding, including private placement debt, direct lending and asset-based finance. Funding plans need to explore all options and use creative thinking. Alternatives such as crowdfunding (equity), peer-to-peer lending (debt) and specialist FinTech service providers are increasingly credible sources of financial solutions for businesses.

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