As the basis blogging has been around the issue of shareholder wealth maximisation, the lectures this week highlighted an interesting means of potentially achieving this… Through optimising the company’s capital structure… so what is this all about?
Capital structure refers to the way in which the company’s operations are financed. Previous blogs highlighted that some companies opt for equity finance whereas others rely on debt finance, or a mixture of the two! But how can this influence shareholder wealth? Is it possible to achieve increased wealth for shareholders by tweaking the capital structure of the company? If so shouldn’t everyone be doing this?!
Theory highlights that the cost of equity is usually higher than the costs associated with debt. This is down to a certain level of assurance with debt compared to equity. WACC suggests an optimal capital structure exists between the two exists and that since the cost of debt is lower companies should take advantage of this and load up on debt… so is this advisable?
It would seem up to a certain point this works… however companies must be careful not to overload on debt. Once the cost of debt rises to a level which exceeds the cost of equity the company has gone too far and should stop loading up on debt. This is due to the main advantage that equity finance holds over debt finance. In times of financial distress companies financed via equity can choose not to issue a dividend and retain the money within the company. However those financed by debt do not have the same level of influence over repayments.
Examples have shown that returns per share increase as debt is introduced into the capital structure. However other factors should be taken into consideration, for example the industry in which the company is operating. Some industries for example the tobacco sector will be remain strong during time of recession, whereas others such as the tourism industry are likely to suffer.
An example in the tourism industry is Thomas Cook. Its board of directors are seeking to reduce the debt of the group in an attempt to yield a more appropriate capital structure. This comes amid lower consumer confidence blamed on conflicts in Egypt and Tunisia along with the Thailand floods impacting on company sales (BBC, 2011).
Achieving a more optimal capital structure seems to be an issue for companies experiencing the negative effects of the recession. It has been highlighted in recent news regarding retailer Peacocks entering administration. KPMG stressed that the company’s current capital structure, with total debt of £750m, as unsustainable (BBC, 2012). Adapting the capital structure is therefore necessary for the company’s future. Another retailer looking to its capital structure as a means of riding out the recession is Blacks Leisure who looked at ways of strengthening the firm’s capital structure in order support its plans for future growth and development (BBC, 2011).
To summarise it would seem that managers view an appropriate capital structure as vital for the development and success of the company’s future. So, maybe the fact that it will also help improve shareholder wealth will encourage companies to consider their capital structure in more detail in relation to their future success.
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