Reading: Towards an Optimal Capital Structure

The following graph summarizes additional potential costs and benefits of debt financing, which we briefly discuss below.

 

 

Additional Costs of Debt Financing

 

Distress costs

One of our original assumptions was that there are no costs of financial distress. Put differently, the amount of debt financing does not in any way affect the current and future business relationships with the relevant stakeholders and in the case of bankruptcy, the debtholders take over the assets in a costless transaction.

Clearly, these assumptions are not very compatible with reality. In reality, there are potentially significant direct and indirect costs of financial distress:

• Direct costs of financial distress (bankruptcy costs): Financial distress is expensive. Some of these costs are the direct result of being in distress. For example:
  • Legal fees for lawyers, courts, expert opinions, etc.
  • Auditor fees for special audits etc.
  • Management time and fees, for example for the appointment of turnaround managers or because distress absorbs a significant amout of management time
  • Etc.

 

• Indirect costs of financial distress: Importantly, distress costs can occur even if the firm avoids bankruptcy (or long before it enters bankruptcy). These are the so-called indirect costs of financial distress:
  • Suppliers might require payments in advance instead of granting generous credit terms
  • Customers might be reluctent to purchase goods because they fear that the firm will not be there to provide after-sales support (or warranty claims)
  • Employees might leave the firm, hoping to find new employment before all other colleagues flood the job market. Those who stay might ask for higher salaries as a compensation for their higher job risk.
  • The coffee breaks that were used for creative discussions that bring the company forward are now dominated by uncertainty and speculations about the firm's future.
  • Etc.

 

These costs of financial distress can be substantial. Already the faint prospect of financial distress can throw a spanner in the smooth works of the company. When deciding about the optimal financing policy, these costs should clearly be considered.

 

Liquidity drain

A rather obvious point is that debt financing eats into the firm's future liquidity. The contractual future debt payments must be made before the firm engages in additional investments or distributes cash to its shareholders. A high debt level could therefore jeopardize the firm's future investment and payout policy.

This is often an important consideration in leveraged buyout transactions such as management buy-outs (MBO) or management buy-ins (MBI). Often, these transactions are financed with quite significant debt portions. For a detailed case of such a transaction, please refer to the module Financial Planning for Managers. There, we look at debt-financed MBI transaction that factually absorbs the firm's cash flows for the 5 years following the deal. During that time, the firm will predictably be unable to make significant new investments or pay dividends to the shareholders. This could be a competitive disadvantage in a dynamic environment.

 

Loss of flexibility

Related to this point, is the more general loss of flexibility that debt financing brings about. Above, we have discussed how firms migh lose the flexibility to make new investments and pay dividends as a result of the liquidity drain.

With debt financing, firms also give away parts of their strategic and operating flexibility. As we have seen in the discussion about debt covenants earlier in this module, debt contracts generally prevent firms from changing their business in any material way. This impairs their flexibility to react quickly to changes in the market environment.

 

Higher equity risk

Finally, we have seen at various places already that debt financing makes the equity claim riskier. In perfect markets, this is irrelevant because shareholders can use home-made leverage to calibrate the riskiness of their equity investment. 

In reality, however, this is often not possible, especially in the context of privately held firms. Entrepreneurs often have a significant portion of their total wealth invested in the company and therefore bear considerable business risk. They cannot diversify this risk without giving up control over the firm.

Issuing debt to pursue new project means that the entrepreneurs assume a financing risk on top of the firm's business risk. This might prevent them from pursuing a more aggressive debt policy.

  

 

Additional Benefits of Debt Financing

Let us now turn to some of the additional benefits that debt financing could have:

 

Issue Costs

Raising capital is not free of charge. Especially in the context of public capital placements, there are several costs associated with the issuance of new capital, including professional fees (legal, audit), listing fees, and underwriting fees (i.e., fees paid to the investment banks). 

Lee, Lochhead, Ritter, and Zhao (1996) estimate the total direct cost of issuing capital.  Though the numbers are a bit dated, the general message would still seem to apply today:

• Issuing equity is generally more expensive than issuing debt.
• The total direct costs of issuing equity for the first time to public investors, a so-called initial public offering (IPO) amount to approximately 11% of the gross proceeds.
• For seasoned equity offerings (equity offerings by listed firms), the cost drop to roughly 7% of gross proceeds.
• In contrast, issuing bonds costs only rougly 2% of gross proceeds, on average.

  

Managerial Agency Costs

In the previous section, we have seen that debt financing could create an agency problem between debtholders and shareholders which could induce shareholders to take actions that are not in the best interest of the firm or the debtholders.

There are other potential conflicts of interest within the firm which could be related to financing decision. In particular, agency problems between shareholders and managers. In larger and more mature companies, the owners (shareholders) generally delegate the management of the company to the management team.

But how to make sure that managers work in the best interest of the shareholders? As in the case of debt financing, it is generally not possible to write a perfect contract, so that there will always be situations where managers have residual decision rights, which are hard to verify for the shareholders.

In this context, debt financing could serve a very simple purpose: Drain the firm's liquidity so that managers don't waste it on unprofitable projects!

Consequently, the "liquidity drain" that we have discussed as a potential disadvantage of debt financing could also be an advantage, in the sense that sufficient debt financing puts pressure on the management to work hard to be able to meet the financial obligations.

 

Asymmetric Information

Another important assumption that we have maintained for our analysis of capital structure policy is that of homogeneous expectations: All market participants have the same information and they read that information the same way. In reality, insiders (managers, inside shareholders) have usually much more information about the firm and its prospects than outsiders (outside shareholders, debtholders, etc.). Put differently, there is asymmetric information between insiders and outsiders. 

In the presence of asymmetric information, outsiders have to form their opinions and investment decisions based on the information they receive and the corporate actions they observe. One of these corporate actions that could convey information to outsiders is the firm's financing policy. 

• In particular, firms could use debt financing to signal the market that they are confident about their future ability to fulfill the financial commitments that the additional debt brings about (interest payments and notional repayment). Issuing additional debt could therefore send a positive signal to the market, especially at times with greater uncertainty.

• Among similar lines, the fact that a firm obtains debt financing shows the market that professional lenders consider the firm an attractive investment target. Especially if the lenders in question are of good reputation, this certification signal could convey positive information to the market.

• Equity financing, in contrast, could send a negative signal to the market. In the presence of asymmetric information, outside shareholders could wonder why the firm decides to issue additional shares.
  • If managers believe that the firm is undervalued, they will most likely refrain from issuing new shares, simply because that would mean that they give away the shares at a price that is lower than their "fair value."
  • In contrast, if managers believe that the firm is overvalued, issuing shares at a high price could be an attractive proposition to managers, as they can sell high.
  • To the extent that market participants understand this, equity issues could be considered bad news, as they signal the market that the management thinks the firm is overvalued.

    

No Dilution

Finally, an important argument in favor of debt financing is that it does not affect the firm's ownership structure. Therefore, if the firm issues fresh debt, the ownership claims of the incumbent shareholders are not diluted. In contrast, raising fresh equity generally means that the firm invites in new shareholders. Their ownership stake comes at the expense of the existing shareholders and, therefore, dilutes the ownership structure.

Since control is valuable, both economically and psychologically, many firms are reluctant to issue equity. This is especially true of privately held firms that are under family control.

Note that, in principle, dilution of ownership could be avoided, at least partially, by issuing new shares with limited voting rights. The module Deal Structuring briefly discusses how such arrangements could be used to separate ownership and control with equity financing. The problem is, however, that investors will often not be willing to accept such securities because they factually put them at the mercy of the controlling shareholders: They would be left with is the right to hope for a dividend. That is not a particularly strong right.

  

Summary

This section has briefly discussed additional costs and benefits of debt (and equity) financing. We have seen that there are good arguments on both sides of the aisle.  Depending on the relevance of these arguments, different companies will therefore have different "optimal" capital structures. 

With this, we are now ready to think in a more structured way about the firm's "optimal" capital structure. In what follows, we discuss two popular approaches to answer this question:

• The pecking-order theory, and
• the trade-off theory.