Monday, January 18, 2010

Maintaining an Optimal Capital Structure

Capital Structure : In simple terms it is nothing but the propotion of various sources of financing . Generally capital structure signifies the Debt/Equity ratio of the company(because debt and equity are the major source of financing for a firm)

Why is it important : To give you a background , equity source of financing is costlier than debt source . Hence companies prefer debt as a source of financing . But there is a catch here . Equity though it is costly , it is just a notional value(meaning we never really pay anybody except in the case of dividends , which is also not mandatory) . But, debt, eventhough it is cheap , is a fixed cost .Hence while looking out for financing through debt , it is important to understand the debt repayment capacity of a firm(Bankers use Interest coverage ratio in case of balance sheet financing, or Debt Service Coverage ratio in case of Project Financing) . This basically sees whether the company has stable source of income to repay the debt it has incurred.

Advantge with Debt : Now as i said debt has a lower cost advantage ; it has the tax benefit - meaning the company does not have to pay tax for the interest component . This was a theorem proposed by Miller-Modigilani V(Levered) = V(Unlevered) + T.D

But the drama does not end here . These guys also say that whenever a firm increases its debt the perception of the riskiness associated with the firm increases which leads to what the academicians call as 'bankruptcy cost'.

So whenever a firm starts increasing their debt in propotion to equity , the overall cost of capital reduces till a certain point and then it starts to increase back . The inflection point is the point of optimal capital structure . The firm should maintain the capital in that particular ratio as the valuation of the firm can be maximised at this capital structure.

But the optimal capital strutcure is not same for all the firm and it varies generally across the industries . That is the precise reason why some firms thrive on more debt(like construction companies) and some firms take very less debt on their balance sheet(software companies - zero debt).

My next post will be on intutive arguments as to why each industry is having a particular D/E ratio.