The term “capital structure” refers to the specific mix of long-term debt and equity a company uses to fund its operations and assets. For the CFO of a multi-site capital intensive business, or any major corporation, determining the perfect blend of debt and equity is a continuous balancing act aimed at maximising firm value while minimising the cost of capital.
The Illusion of the ‘Ideal’ Structure
In a theoretical world without taxes, bankruptcy costs, or asymmetric information, the Nobel Prize-winning Modigliani-Miller (MM) Theorem suggests that capital structure is irrelevant to firm value. However, the real world is messy, meaning a choice must be made, and that choice is governed by the Trade-Off Theory and the Pecking Order Theory.
The ‘ideal’ or ‘optimal’ structure is thus defined as the specific mix of debt and equity that results in the lowest Weighted Average Cost of Capital (WACC) for the firm.
1. The Attractiveness of Debt (The Leverage Advantage)
Debt is generally cheaper than equity for two primary reasons:
The Downside: The major drawback of debt is the increased risk of financial distress and bankruptcy. As debt levels rise, so does the probability of default, increasing the cost of both debt and equity.
2. The Attractiveness of Equity (The Flexibility Advantage)
Equity (retained earnings or new stock issuance) provides greater financial security and operational flexibility.
The Downside: Equity is expensive. Existing shareholders may face dilution when new shares are issued, and equity holders demand a higher return (due to their residual claim) than lenders.
Industry-Specific Capital Structures
The “right” balance is heavily dependent on the industry’s characteristics, especially its stability, asset base, and growth prospects.
For a multi-site capital intensive business, the CFO aims for a structure that supports aggressive, capital-intensive expansion (new sites, equipment) through debt, while protecting the business from revenue volatility using a healthy equity base. The metric EBITDA Contribution Margin (a key measure of site-level financial health) is critical for demonstrating the capacity to service debt.
Further Reading for Deeper Understanding
To explore the intricacies of capital structure and corporate finance in depth, these books are highly recommended:
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen: The definitive, comprehensive academic text, covering MM, trade-off theory, and real-world capital budgeting.
- “The Little Book of Value Investing” by Christopher H. Browne: While focused on investing, it grounds financial analysis in balance sheet health and provides practical context to risk.
- “Corporate Finance: Theory and Practice” by Aswath Damodaran: Known for his practical and clear approach, Damodaran provides excellent, intuitive examples of how to apply theory to real-world valuation and structure.
Did you find these insights valuable? Follow Stewart & Smith Advisory for more expert guidance on navigating the complexities of business finance.