AFM – Financial Strategy Formulation

The Optimum Capital Structure of a Company

THE ROLE OF THE CORPORATE FINANCE MANAGER

● Financing existing and planned investments:

○ An optimum mix of the two main sources of finance (equity and debt).

● Minimising the cost of company’s capital:

○ Value creation for shareholders.

THE IMPACT OF GEARING ON COST OF CAPITAL

● Enables the organisation to lower its cost of capital:

○ Advantage of debt financing – cheaper source of finance

○ Disadvantage of debt financing – risk associated with high gearing

● From the perspective of expected return:

○ Assume less risk;

○ Expect fixed return (return);

○ Relatively less risk as compared to shareholders; and

○ Considered a cheaper source.

● From the perspective of tax benefit:

○ Interest is a tax-deductible expense;

○ Debt provides tax shield; and

○ Lowers the average cost of capital.

 ● From the perspective of business risk:

○ Interest is an obligation;

○ Fixed payment increases overall business risk;

○ Reduces the flexibility of returns;

○ High gearing increases the return expectations of shareholders; and

○ Increase in average cost of capital.

● From the perspective of cost of issuance:

○ Cost of issuing debt is considered relatively less than issuing equity.

● From the perspective of other risks involved:

○ Debt financing is associated with interest rate risk;

○ Risk can be managed by hedging.

OPTIMUM CAPITAL MIX

● At a certain level, debt helps lowering the cost of capital due to associated:

○ Lower cost; and

○ Tax shield.

● Beyond that point, the associated risk due to high leverage rises and, therefore, the average cost of
capital as well.

● Theories that help identify the optimal mix:

○ Modigliani–Miller theory;

○ Static tradeoff theory; and

○ ‘Pecking order’ theory.

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● Practical issues:

○ Availability of debt:

■ Market of loans – banks less willing to lend.

 ■ Market of bonds – investors less interested to lend.

○ Cost of debt:

■ High leverage is associated with high risk, which in turn increases the cost of debt.

○ Restrictions imposed by articles of association.

○ Restrictions imposed by existing lenders (credit covenants).