Emphasis on Capital Structure is Vital in Delivering Value to the Stakeholders

So how is the capital structure not important? When there is debt, there will be priority claims on the assets of the firm, and the debt holders have to be paid first before the equity holders are paid off. This also changes the risk profile of the firm, and the cost of capital (which is risk-adjusted) changes, thereby changing the value of the firm. The value would change positively if the priority claims on these assets comes down, thereby improving the risk profile of the firm. This change in the risk profile of the firm – and, therefore, the change in cost of capital – would anyways happen whether the firm operates in a tax or no-tax world. Therefore, the relevance lies in the capital structure of a firm to create value for its stakeholders.

Having set this pitch; let me substantiate this in a more detailed way with, something that I term as, the Briefcase Theory in highlighting the importance of capital structure and its impact on the firm and the stakeholders…

The Briefcase Theory

This terminology (which you will never find in a corporate finance text book) is usually used by me when it comes to explaining the relevance of capital structure and its resultant impact in changing the value – The Briefcase Theory.

Let’s assume a person is carrying $100,000 (for ease of understanding, please read this $100,000 as total capital of the firm) in a briefcase, which is being held in his right hand. At some point of time, he shifts the position of the briefcase and moves it to his left hand. So what essentially changed is the position of the briefcase (from right to left hand) but not the total capital (it still remains to be $100,000).

This is what we call altering the structure of the capital from right to left hand (i.e. from equity to debt or vice versa). But in doing so, the risk profile of the $100,000 in the briefcase changes. So the question is was it more risky being in right hand or does it get riskier when the briefcase was shifted to the left hand? That will help in determining the cost of capital – and hence the emphasis on the capital structure.

Now let’s give another angle to it – the same person was carrying two briefcases. The left hand side was empty and the right hand side is filled with $100,000 (c. Total capital as equity). After some point, the person decides to hedge the risk and shift some of the money from the right briefcase to the left briefcase (c. $40,000 shifted to the left briefcase). This is when debt is introduced in the capital structure. The below points is the outcome of this capital structure –

• Change in Risk / Reward Ratio – Based on the above explanation, the equation of the capital structure changes from 100% equity to 40:60 debt to equity. This implies the firm now has less equity in the latter scenario, and, therefore, the ROE would go up and so would the EPS – tax or no tax condition – thus underlining the conviction that debt does add value to a firm’s stakeholders, and hence the relevance of capital structure.

  But if the proportion of the capital structure equation keeps on shifting more towards debt (c. 60:40 Debt-Equity ratio), the cost of risk would increase since the priority claims of the debt holders on the assets of the firms would also increase, thereby increasing the risk profile of the firm. This adverse change in the risk profile of the firm would have a double whammy effect.

  First, this would push up the cost of equity (Ke) as the required rate of return for the equity investors would go up with increased riskiness of the assets (so even though the firm may report higher ROE, there will be value erosion due to higher cost of capital); and second, because of the higher leverage, the coupon rate enjoyed by the firm hitherto would also go up, thereby pushing up the cost of debt (Kd).

  With rise in both Ke and Kd, the WACC of the firm would go up – tax or no-tax situation – and this will negatively impact the value of the firm. As the firm starts paying off the debt, the priority claims on the assets begins to come down and so the Ke.

  However, there is a trade-off between the benefit unlocking because of introducing debt and increase in cost of risk (due to priority claims), beyond which addition of debt starts eroding value – this trade off point becomes the optimum capital structure – and hence it underlines the importance that the capital structure of a firm is extremely
  important in creating value for its stakeholders

• Tax Benefit / Shield – In the world of taxes, the benefits reflecting in the cash flows would be higher with a debt in the capital structure than 100% equity; however, in a no-tax situation, the cash flows won’t change irrespective of the capital structure
• Bankruptcy Risk – As the proportion of debt increases, the cost of risk increases (as already mentioned above in point 1). Beyond a certain point, the firm heads toward financial distress. As a result, the projected cash flows of the firm would come down for reasons related to default risk, and the discount rate would significantly go up, thus eroding value
• Agency Cost – Because of debt being introduced in the capital structure, the owners of the business would run it differently due to agency covenants as opposed to the way they would have run with 100% equity

The key takeaways from the above discussion is that a) capital structure is extremely relevant and important since it determines the value of the firm and its stakeholders based on its risk profile, b) debt does add value to the equity owners, but only until the optimum point, beyond which it begins to erode value, and c) a highly leveraged situation pushes the firm toward default risk and leads to significant erosion in value – whether tax or no-tax situation.

So Why Does the Concept of Leveraged Buyouts is in Existence and Practiced?

As we are all aware that Leveraged Buyouts (LBOs) transactions are highly leveraged with unprecedented level of debt in the capital structure, a question might arise that, if a highly leveraged firm tends toward default risk, then why the concept of LBO is in existence? Is the capital structure not relevant when it comes to LBO transactions? The answer to this lies in understanding the dynamics of LBO and how it intends to reach to the optimum capital structure equation in due course.

I would put it in a simple way (for ease of explanation) that LBO transactions are like buying a house in a good locality, where you know the price of the asset (house, or in this case the business) would appreciate by c.5x in the next 3 years. You also have a steady flow of income (that’s the cash flow of the business) with which you are able to pay off the periodical debt obligations, or maybe even partial pre-payment (in addition to the contractual obligations) if the cash flows are really good.

By doing so, you are increasing your equity stake (or as I would say priority claims on the asset) on the house, which is appreciating from the levels you have bought, although the balance sheet would still show it at book value; but let’s keep this angle aside for the time being. Therefore, in this situation, as the business starts retiring debt, the proportion of the equity in the overall capital keeps increasing, and, therefore, the capital structure begins to change favorably.

So there is a positive double whammy effect involved – a) that you are retiring debt at book value (obviously the assumption is that it is a plain vanilla debt and not marketable bonds) and claiming your stake on the asset at market value – this is what creates value to the equity holders as the business starts retiring debt and reduces the priority claims of the debt holders on the assets of the firm.

To Conclude…

I would say that I have a great deal of respect for the classic M-M model, and this model holds good from a company’s operating perspective, i.e., it does not matter how the business is financed so long the cash flow of the business is able to honor the debt servicing. But, it does become extremely important and relevant from an investor’s perspective – tax or no-tax – since his required rate of return will include a risk premium based on the riskiness of the firm’s capital structure, and that will become the key in determining the value the business can command from the investor.