Capital Structure Question
(Chimp, 8
Points)
on 3/6/08 at 1:52am
My friend received this in an interview, I'm not sure how to best answer this:
"What factors contribute how to determine the optimal capital structure of a firm? What are the benefits of each?"
-I would talk about the risk/cost that come with debt and equity. But, I would like to hear more elaborate responses.
Thank you.
Think about relaxing the
Think about relaxing the assumptions of MM theory and then see how they individually affect the capital structure of a firm. This answer is much more theoretical than practical.
In a MM world, financing with debt or equity makes no difference. Taxes always play a role in the capital structure you choose, so do bankruptcy costs, incentives for the entrepreneur(firm leaders), and assymetric information. The reasons these affect capital structure can be found in a finance textbook. The pecking order theory may also be useful in the conversation but really only applies when a company needs to finance a new project.
If you want a more practical answer, ask someone who is already working, I won't really know until the fall.
Yeah, def. agree with the
Yeah, def. agree with the poster above. I would've said something like "In a perfect capital market, structure is irrelevant. But given that we obviously don't have one of those, there are a few things that companies can look at. With taxes present, adding leverage increases the value of the firm, because it increases the amount that the firm can write-off of its taxes. Thinking this way, it would be optimal for a company to be fully levered. However, there are also costs of financial distress (restructuring charges, lost business, etc) that pull down the value of the firm once leverage gets above its optimal level. If analysts can predict T* (the net benefit to leverage) relative to firm value and leverage, then they can use that equation to find L* (the optimal leverage ratio) by taking its first derivative (as the value of the firm is maximized when T*'=0)."
Great answers from the
Great answers from the posters above.
In an interview, the interviewer is trying to see if you understand the basics about WACC and the differences of cost of equity and cost of debt. Don't go too deep unless you're asked to. For most industries the optimal capital strucutre is achevied around a BB+ rating.
Your cost of debt increases as you increase leverage. For example, a company like Microsoft with no debt, can easily raise large sums of funds in the commercial paper market at around 2.7%. After factoring in a tax rate of 35% (effective tax rate should be lower) the effective cost of debt drops to 1.75%. If I were to buy a share of MSFT, I would expect to make more than 1.75% (through dividends and share appreciation). Debt for MSFT is much cheaper than equity. Once you become very levered, debtholders want a higher and higher interest rate, and soon issuing equity becomes cheaper.
In addition to cost, there is flexibility available with each product. Cash outflows from equity are more flexible than coupon payments on debt. Although companies generally have sticky dividends, they choose when to provide special dividends and share buybacks to return cash to shareholders.
Bankruptcy costs and franchise valus destruction are factors that I really didn't consider before I started working. Bankruptcy is expensive. Think about all those lawyers. Think about all the value in a company you destory in bankruptcy. As you increase debt, you increase the value of bankruptcy, and you should factor in that cost into your captial structure analysis.
You would also want to consider off-balance sheet debt/contractual obligations. Leases are very similar to debt. You need to pay a fixed amount every month/quarter for a period of x years. Sounds like debt. Off-balance sheet financing vehicles are off-balance sheet, but it really is debt of the company that should be factored into capital structure calculations.