Capital Market Pressures toward the Optimal Capital Structure

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Determining the optimal structure of capital is a difficult task. Simply copying existing or similar structures is a devastating idea. Findings suggest that companies are generally rigid to counter market fluctuations even though the changes have adversely affected their debt to equity ratio. You and your competitor may have a varying debt to equity year on year. This situation has led to an irresolvable debate regarding its meaning and implications:

  1. 1)Whether, the costs of the transaction are high enough to force managers to change the capital structure.(If the argument holds true the best way is to negate paying or repurchasing cost).
  • Is the best capital structure self-restructuring with the current market prices? (If so, firms would not change the capital structures at all as the best structure is self-adjusting).
  • Are companies making flaws by failing not to maximize their capital structures? (If not false, then copying is definitely a bad decision).

Let us dig deeper into the third situation where your conclusion would hang on the fact that you can control the market. If you think that an outsider can profit by mending a bad structure of capital, then you will also assume that the present structures are nearly optimized.

Unfortunately, nothing can be farther from the truth. To counter an incorrect financial decision one will have to stage a takeover. Any acquisition requires premium over the current price (up to 30% in some cases) plus fees to investment banker facilitating the process. To takeover, such a huge premium mending an incorrect structure of capital must create real benefits. Justifiable estimates for the increase in value while moving to the best capital structure varies from 1% to 3% pa.

Even after many years of capitalization, the value reaches up to the ceiling of 30% to the maximum.

Then the question arises whether the inability of outsiders to rectify and mend capital structures makes them dispensable? No. The inside management does not have to pay a control premium. Hence they face a different scenario. For them, 1-3 percent premium is a moderate amount which is also risk-free. For huge companies like IBM, the value generated is to only cover for the consultation fees! To sum up, though shareholders have limited or no effect on internal managers still they should try to make it right.

Coming back to the central question, whether we can copy existing capital structures for optimal performance. There are numerous reasons against copying.

The capital structure of the comparable may consist of both good and bad financing which only the respective manager can fix. So it is not necessary that it is an optimal structure reflecting the present market scenario.

Also, the managers’ motives are driven differently from the shareholders. They like uninhibited cash flows, flexibility towards decision making and absolute control. So it is your choice whether to increase the valuation of the firm or provide more comfort to the managers.

Comparable capital structures on closer introspection may reveal that they are not comparable at all.

Also maybe being different is what adds value to your firm. As an example, if all your competition is in debt you might predict that a recession will blow away all your competition. (Lowering the debt/capital ratio is an option, not an obligation, but there are places in the world where the option can be immensely successful).

In a nutshell capital structure and control is not determined with pin point precision, unlike stock markets. So a manager cannot depend on a self-restructuring capital structure dependent on market forces. Knowledge about comparable managers is good and can be helpful.

Capital Market Pressures toward the Optimal Capital Structure 7


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