Capital Structure and the three bears

Throughout previous weeks a theme that has been common throughout some of these blogs is the idea of maximising shareholder wealth. It has been made apparent, throughout this weeks lecture that utilising capital structure can be an effective method of contributing to this objective.

Capital structure can be defined as the method at which a firm finances its operations and growth by using different sources of capital. For example, one of my previous blogs covers the idea of equity vs. debt, well; capital structure is the method at which managers use both of these capital sources to achieve their optimal capital structure.

Traditionally it was believed that simply increasing the gearing of a firm, i.e. the debt would be most beneficial as this would produce the cheapest rate of borrowed funds, creating the lowest WACC and therefore enhancing shareholder wealth. Debt is considered cheaper than equity due to the fact that: lenders usually expect lower rates of return than shareholders, debt can actually be paid off before the business’ profits are taxed, resulting in less tax being paid by the firm and finally, the transaction costs associated with debt are usually less expensive than those incurred by equity.

However, unfortunately raising capital through debt does have its disadvantages. As gearing increases, so do the annual interest repayments and unlike dividends, firms are required by law, to pay the interest. As a result, interest repayments that get too large can result in a firm being unable to pay dividends to shareholders, lowering shareholder wealth and opposing the aim of optimising capital structure in the first place. In more extreme scenarios firms may have to enter liquidation to pay off their debts and could even end up having to declare bankruptcy!

There is a way of achieving this optimal debt to equity ratio; if the gearing is too low then the benefits of low cost borrowing are lost, whereas if debt is too high then the company could be deemed a very risky investment.

The idea reminds me of the story Goldilocks and the three bears, it’s all about finding that perfect bowl of porridge…

However, finding the optimal capital structure can be difficult, particularly if your firm is largely affected by changes in the market. For example, if a firm has a capital structure that relies heavily on debt, it can often find itself in trouble during times of turmoil.

Companies with this sort of capital structure have been hit worse by the economic recession. As stated previously, companies that raise capital through debt must pay their interest repayments regardless of their financial performance whereas companies that have raised finance through equity can choose to avoid paying out dividends, retaining the capital to sustain future operations and growth.

Many companies that have been hit hard by the recession have found themselves struggling to pay interest repayments on their debt. One of the largest UK companies to buckle under the weight of their debt as a result of the recession was Woolworths. In November 2008 the high-street chain went into administration after struggling to cope with repayments of its £385million of debt (BBC News, 2008). The firm had been described as a “lame duck” by the BBC, a term usually used to refer to politicians that were known to be in their final term of office. Woolworths had been losing market share to intense competition over the previous years and a vicious cocktail of declining sales and heavy debt repayments were the cause of its demise.

In its final days, the 'company had tried to sell itself for the nominal price of £1' (BBC News, 2008) with the new owner taking on the company's huge debt. Unfortunately, the desperate plea for someone to inject life back into the firm, fell on deaf ears.

Perhaps if the firm had re-structured its capital, taken a more equity focused approach it would’ve been able to weather the storm of this recession. Retaining any cash reserves, withholding dividend payments until things began to look up.

Although, are shareholders likely to hold onto shares that aren’t offering any returns? What use is holding equity in a firm that’s bleeding market share? Ridiculed by the media as a “lame duck”, hardly screams great investment. Maybe then this end was unavoidable for Woolworths; a strategic re-structure of capital may simply have delayed the inevitable. 

Sources used;

BBC News (2008) 'Woolworths set for administration', The BBC News Website. [Online]. Available at: http://news.bbc.co.uk/1/hi/7751064.stm (Accessed: 01/04/12).