“The first question is, is when you have capital, is it better to keep it or return it to shareholders? It’s better to return it to shareholders when you cannot create more than a dollar of value with that capital. That’s test number one. And if you pass that threshold, that you think you can achieve more than a dollar of value for every dollar retained, then you simply look around for the thing that you feel the surest about, and that promises the greatest return weighted for that certainty.”
Measuring capital comes down to multiple metrics: ROIC (return on invested capital), ROE (return on equity), or ROCE (return on capital employed). Determining the company’s capital helps investors ascertain how efficiently and effectively management deploys that capital, which the metrics help us measure.
But what is the optimal capital structure? Each company’s structure will depend on multiple factors, and how they organize that structure will determine many of the CEO’s decisions to grow the company.
After all, capital management is job number one for the CEO, and part of our analysis is studying those decisions and the capital structure of each business.
In today’s post, we will learn:
- What is Capital Structure
- Understanding Optimal Capital Structure
- How to Determine the Optimal Capital Structure
- What Are Three Factors Influencing Optimal Capital Structure
Okay, let’s dive in and learn more about optimal capital structure.
What is Capital Structure
In the simplest terms, capital structure is the specific arrangement of debt and equity a company uses to finance its operations, overall operations, and potential growth.
Let’s explain equity and debt a little.
Equity capital or financing comes from ownership of shares in a company with claims on its future cash flows and profits. When investors buy shares in a company, say Microsoft, we become part-owners, but we also grow the company’s equity capital with our investment.
Debt capital comes from bond issuances or loans, which the company offers to raise capital. The bond offering extends debt to buyers in return for a coupon or dividend payment, plus the return of the original loan at a predetermined time.
The equity capital comes from common stock, preferred stock, or retained earnings. Short-term debt, such as capital leases, is also a part of the company’s capital structure.
We can find both debt and equity on the company’s balance sheet. The company’s assets, purchased from either debt or equity, are also on the balance sheet. Those assets drive the company’s growth, whether inventory, accounts receivable, or intangible assets in a cloud SaaS company.
Capital structure can be a blend of long-term debt, short-term debt, common stock, or preferred stock, and how the company chooses to finance those assets is part of our capital structure analysis.
For example, some companies may use short-term debt to finance a shorter project, while others may choose long-term debt for longer projects. Or they may choose a mixture of the two, depending on their financing needs.
A great metric to give you a quick insight into the capital structure of a business is the debt-to-equity ratio, which compares the debt levels to the equity, and generally, the higher the ratio, the more aggressively the company uses debt to finance its growth.
There are other metrics you can use to measure a company’s capital structure, such as:
When analyzing companies, always remember that each industry or sector will be different; for example, a company’s capital structure in the energy or utility sector will vary wildly from a company in the cloud SaaS sector.
Understanding Optimal Capital Structure
The optimal capital structure for Target depends on the best mix of debt and equity financing that optimizes the company’s growth prospects while reducing or minimizing those capital costs.
In theory, debt financing is the cheaper of the choices. Companies can benefit from debt financing because of its tax advantages; for example, interest payments made on debt borrowings can be tax-deductible. During times of low-interest rates, debt is plentiful, easy to access, and much cheaper. All of these reasons help drive down the cost of debt, which lowers the cost of capital.
Before digging further, let’s make sure you understand the cost of capital; below is a deeper dive:
We also should remember that debt allows Target to retain ownership control, whereas equity dilutes ownership by allowing outsiders to take partial ownership when buying Target’s shares.
Equity is more expensive than debt, particularly when interest rates are low, such as now. However, an advantage of equity financing is it doesn’t have to be paid back or reduce earnings with interest payments.
Several types of capital structure impact the optimal capital structure and those costs we discussed.
High-leverage firms carry higher debt loads, which allows more company control but carries higher risk and reduces earnings from interest payments.
Low-leverage firms carry lower debt loads, increasing earnings because of lower interest payments but diluting ownership and costing the company more capital expenses.
The optimal capital structure maximizes the company’s growth while minimizing the cost of capital of the company. The lower the costs of capital, the higher the present value of Target’s future cash flows, as the discount rate or hurdle rate is lower.
The CEO’s job number one is to allocate capital well. The CFO’s (chief financial officer) job is to find the optimal capital structure that maximizes Target’s value while minimizing those costs of capital or WACC.
How to Determine the Optimal Capital Structure
We can think of the optimal capital structure as the proportion of debt and equity that results in the most value and the lowest cost of capital, but no lower.
As mentioned earlier, each industry or sector will have a different view of optimal, and what works for Target might not work for Walmart and Amazon. And the capital structure of Apple would never work for Exxon because of the capital needs of each business.
Apple is a software business and requires less debt or equity to finance its growth because it can use cash flows to buy the assets it needs to continue that pattern. With its capital-intensive nature, Exxon requires debt financing to buy the longer-term assets it needs to generate cash flows. For example, one oil rig can cost upwards of $600 million, and the company may need dozens of those rigs to reach the oil it needs to produce its products for sale.
There is no perfect optimal structure, and each company, industry, and sector will have a combination that will work best for each.
You also have to factor in the company’s strategic or philosophical view.
For example, Warren Buffett of Berkshire Hathaway is reluctant to use debt or equity to acquire the assets the company needs to operate. Instead, he uses the company’s free cash flow or earnings as his capital allocation method, whether buying another business or reinvesting in equipment needed for BNSF (railroad).
Buffett feels that adding additional debt or diluting the company by selling shares are poor capital allocations for Berkshire shareholders. They generate enough cash flow or earnings to allocate capital sensibly without putting the company at additional risk with higher debt loads or diluting shareholder’s ownership.
The company’s capital structure is a combination of assets, debt, and equity, but there are investment dynamics that investors need to consider when analyzing the capital structure.
No ownership rights
Debt investors hold less risk because they have the first position in the event of a default or bankruptcy. That is why bond investors accept lower rates of return, which helps lower Target’s cost of capital when it issues debt compared to equity.
Equity investors take higher risks because equities are far more volatile, and the return, while higher over the long term, in the short-term, can be lower. But for those higher levels of risk and higher returns, Target expects higher costs of capital to trade off for the higher returns.
Let’s look at the capital structure of the three leaders in retail, Target, Walmart, and Amazon, and see how they compare. Then, we can compare those to another industry, say utilities. All the numbers below will be in billions unless otherwise stated:
As we can see quickly, all three companies carry higher equity to assets than debt, which means they use a higher equity strategy to generate assets than debt to generate assets. All three companies generate high levels of cash flows, which Target and Walmart use to buy back shares and pay dividends. In comparison, Amazon reinvests back in the company at a higher level.
Neither choice is right or wrong; instead, it comes down to the company’s strategic and philosophical goals and how it chooses to generate growth. Amazon historically chose to reinvest all of its cash flows into growth, whereas Target and Walmart chose long ago to begin paying a dividend and reinvest at a slower pace.
Let’s look at the capital structure of a few of those from the utility sector:
As we can see, the utility sector uses debt and equity to grow. For example, if we look at Southern’s cash flow statement, we can see the company issued $29.9 billion in debt and $8.9 in equity over the last ten years, respectively. Looking at the same period for Target, we see they have bought back shares to $20.7 billion and reduced debt by $9.78 billion.
That brief look at the different sectors tells me that the retail giants are growing by working from their cash flows, with excess returns reducing their debt and share counts, improving shareholders’ position while growing the company’s revenues.
On the opposite side, Southern is a far more capital-intensive business. To raise funds to grow the company, they need to issue a combination of equity and debt, with the mixture trending towards the cheaper cost of debt.
Again, each sector, industry, and company will have different choices, but within each sector, choosing to optimize the capital structure to grow at a cost that makes sense.
What Are Three Factors That Influence Optimal Capital Structure?
Many factors influence how a company will determine its particular optimal capital structure.
- Expected cash flows: Target’s expected cash flows must be predictable enough to meet obligations (interest payments) and repay any bonds at expiration. Along with generating enough excess returns, they could further generate growth by investing in projects or products to further their revenues. Or by returning capital to shareholders via dividends or share buybacks.
If Target can’t generate predictable cash flows, the company needs to turn to alternate sources of capital, such as debt issuance or equity financing.
Companies with a more optimal capital structure typically have higher capital ratios, such as ROIC or ROE, which tend to generate higher P/E ratios, translating to higher share prices.
- Stability of sales: As with cash flows, sales stability helps Target meet any debt obligation while generating predictable cash flows. Suppose a company doesn’t’ have predictable sales; they might need to turn to other sources of capital, such as debt or equity.
- Cost of capital: The decision on what type of capital structure works best will fall to the mix that works best. For example, if a company raises more debt, then the cost of capital will decrease because the cost of debt is lower, and as the proportion increases, it helps lower the cost of capital.
But if a company continues to increase its debt, there comes a time when the excessive debt load crosses over to become an increased risk, which drives up the cost of equity.
The cost of equity increases with higher debt loads because the perceived risk of default increases the volatility, a key variable in the cost of equity.
Another consideration of capital structures is mergers and acquisitions or M&A activity. When another company merges or acquires another, the capital structure of the company buying or remaining may change, sometimes drastically.
For example, when Square decides to purchase Afterpay using its shares as a form of payment, that will increase Square’s cost of equity on its balance sheet. Instead, if Square decided to fund the purchase with cash (generated by debt), it would have increased the debt on the balance sheet.
The acquisition also alters the asset side of the balance sheet by growing the goodwill or intangibles, depending on the capital structure of the other company. There is also the acquiring of additional debt, which the acquiree needs to pay down, either at purchase or over longer periods.
The increase in assets drives down the returns on invested capital, and the increase in equity drives down the returns on equity. Both return metrics help investors determine how well a company invests its capital or equity in growing the company. And any company that acquires another runs the risk of that acquisition lowering the returns versus the costs.
Generally, the bigger the gap between the return on equity and the cost of equity, the more profitable the company. Likewise, with returns on capital and costs of capital. And poor acquisitions, or ones that cost too much, can drive down the company’s returns.
As with any financial decision, deciding which capital structure is optimal is difficult. However, management usually attempts to operate within a certain window of range.
They also need to understand the signals those decisions send to the market. For example, a company recently signaled they were in good shape regarding capital structure. There was a radical downturn in the share price; weeks later, the company said it would issue debt to raise funds.
In hindsight, it was a bad look, combined with the share price drop, that the company was in trouble, accelerating further share decreases.
A company in a good position will try to raise capital using debt instead of equity, avoiding dilution and sending a bad signal to the market.
Using ratios such as debt/equity and equity/assets is a great way to look at a company’s capital structure quickly. You can quickly determine how risky a company is using leverage ratios such as debt/equity and debt/assets.
Analyzing a company’s capital structure is important in due diligence and determining the optimal capital structure that maximizes value. At the same time, minimizing cost is part of the process.
And with that, we will wrap up our discussion on optimal capital structure.
As always, thank you for taking the time to read today’s post, and I hope you find something of value. If I can further assist, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave, a self-taught investor, empowers investors to start investing by demystifying the stock market.