Monday, November 4, 2013

Setting a Capital Structure: The Great Divide

There is a great divide between academics and practioners on how to set a capital structure. Modigliani and Miller (MM) proved capital structure is irrelevant under a set of restrictive assumptions. Once those restrictions are relaxed, especially taxes, capital structure can have a major value impact. Academics have focused on the tax benefits of debt, thru the interest tax shield, to emphasize tax considerations in the setting of optimal firm capital structures Trade-Off Theory . An alternative information asymmetry based Pecking Order Theory also exists.

In practice, taxes have a much lower impact on capital structure decisions than theory would suggest-except for extreme cases (e.g. firms with little or no debt like Apple). In fact, while there is little opportunity to create value thru capital structure, there is the likelihood of destroying value given wrong capital structure decisions-especially having too much debt. Both of the main theories are unfortunately silent on how to determine precise capital structures.

Chief financial officers (CFO) are concerned with effective, not optimal capital structures. This means one which supports the firm’s financial strategy (e.g. dividends, flexibility and control). They are uninterested in minimizing their weighted average cost of capital (WACC).  Rather, they seek to preserve financial flexibility to fund their business plan under a variety of market conditions. This is expressed in their target debt rating from the major agencies including Moodys, S&P and Fitch Survey. Ratings are the language of capital structure just like the price-earnings ratio is the summary statistic for valuation. Ratings incorporate cost (debt spreads), availability (the non-investment grade market is smaller than the investment grade market) and terms (covenants) considerations that dominates other explanations of capital structure.

The ratings based capital structure approach used by most corporate (non Private Equity excluded and the subject of a subsequent post) involves the following:
1)     Ratings Factors: major considerations include firm size, industry and financial characteristics including fixed charge coverage (EBITDA/Interest) and funded debt ratio (FD/EBITDA).
2)     Target Rating: most nonfinancial firms chose a moderate investment grade rating between BBB+ and A-.This provides a balance between flexibility and cost. The target should be based on thru the cycle not just point in time considerations. The final decision is usually one for the board and should be periodically reviewed.
3)     Comparative Peer Credit Analysis: spread peers based on their existing ratings and financial characteristics. Focus on peers with your desired rating to determine your required financial ratios. For example, currently, A rated firms have interest coverage ratios of 3X or above and FD ratios below 3X.
4)     Testing: test against projections to ensure debt servicing ability.

This approach is equally applicable for smaller and private firms which do not plan on obtaining a public rating. Such firms should keep in mind that larger syndicated bank loans will be rated.

I am not criticizing the academic approach. Rather, I am pointing out a disconnect between theory and practice.

More to follow.


(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

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