Can a company's capital structure maximise shareholder wealth?

The capital structure of a company is how it finances its activities - usually through a combination of both debt and equity. Last week it was announced that Norwegian oil producer, Det Norske Oljeselskap ASA (Det Norske), was reviewing their funding options in order to create the optimal capital structure to increase the cash flow it needs for new projects whilst doing this at the lowest cost to shareholders (Bloomberg, 2015). Hersvik, CEO of Det Norske, has noted that the company is able to raise more debt and may also issue more shares - but how should they decide the proportion of debt and equity? Does an optimal capital structure exist? And can this increase shareholder wealth?

The weighted average cost of capital (WACC) is a way of calculating the costs of a company’s capital sources, both debt and equity, which determines the lowest rate of return needed on an investment to satisfy investors (Reilly & Wecker, 1973). This allows a company to determine which investments they can afford and therefore defines the company’s strategic option set as it acts as a hurdle rate for investment appraisal. As a result companies generally seek a low WACC (Watson & Head, 2013), allowing them to pursue more projects which maximise shareholder wealth. The recent oil price crash has reduced Det Norske's cash flows which are needed as they are wanting to take on new projects. By reducing the WACC it will allow the company to invest in these new projects as the company will require a lower rate of return. At first glance, you may think the decision is easy for Det Norske - increase debt as it is cheaper than equity, therefore lowers the WACC thus increasing their scope of possible investments which could increase shareholder wealth.

Decision made?! Not quite.

Whilst increasing debt does decrease the WACC as it is a cheaper source of finance, the traditional view of capital structure suggests that there becomes a point where a company can have too much debt. After this point it starts to become more costly, thus suggesting there is an optimal capital structure (Brusov et al, 2011). Essentially, debt finance is cheaper as lenders require a lower rate of return in comparison to ordinary shareholders. This is because, due to uncertainties and no guarantee of receiving dividends or capital gains, they often demand a higher return to compensate for the risks they are taking, thus increasing the cost of equity. Furthermore the transaction costs associated with raising debt are generally less than those involved in issuing shares and paying dividends and debt interest can be offset with pre-tax profits - reducing the overall tax bill for a company. However the traditional view suggests that there becomes a point where the cost of equity will start to increase as shareholders demand higher returns for the risks they are taking as highly geared companies are seen as risky investments. So it is at this point where a company achieves their optimal capital structure - before the level of debt causes the cost of equity to rise. I take the view that up until this point it seems logical to take on more debt as it is cheaper. However after this point, if a company continues to take on more debt the risk of financial distress increases along with the possibility of liquidation (this concept is summarised in Figure 1). As a result the WACC will increase thus reducing company value and shareholder wealth. Therefore if a company is above or below the optimal level, they are destroying shareholder value. It appears that Hersvik supports this traditional view as he clearly suggests there is an optimal capital structure and he is aiming to achieve it.

Gearing levels, cost of finance and risk of financial distress (Adapted from Arnold, 2012)

 

Whilst Hersvik has noted that the company is able to raise more debt and the equity ratio requirement of 25% has been removed, the company reported a net loss of $287m which could provide problems when trying to raise more debt. Lenders are likely to require higher returns meaning higher interest rates, thus increasing the cost of debt. Furthermore the company will not benefit from being able to offset the debt interest with pre-tax profit. Having said this, it is likely that raising debt will still be significantly cheaper than the costs associated with issuing shares. In addition, due to the current situation and issues Det Norske is facing with the oil price crash this will increase the risk of financial distress and shareholders will demand higher returns to compensate for the risks they are taking, increasing the cost of equity. This demonstrates how there is a fairly complex relationship between debt and a company's capital structure.

An alternative view, which significantly differs from the traditional view, was taken by Nobel Prize winners Modigliani and Miller (1958) who suggested that company value is independent of its capital structure. Instead, the value of a company is entirely dependent on business risk (Modigliani & Miller, 1958). Essentially this view suggests that no matter how much companies play around with their capital structure, it will not change the WACC, thus no optimal capital structure exists. Therefore Modigliani and Miller (1958) would argue that Hersvik's is wasting his time in aiming to achieve an optimal capital structure as such a thing does not exist. The theory behind this was that as the levels of debt increased, the cost of equity would also increase leaving the WACC the same. This suggests that Det Norske should focus on making good investments rather than altering their capital structure as cash flows generated from operations is the only way to increase company value and maximise shareholder wealth. However, in order to make this theory work in practice a set of unrealistic assumptions were made which have been heavily criticised. For example, they assumed that there is no taxation, as discussed above - debt receives a tax benefit, and they assumed there are no costs of financial distress and liquidation when in reality businesses clearly face the costs associated with these for example bankruptcy costs.

These criticisms led to Modigliani and Millar (1963) reviewing their theory to include tax. This dramatically changed their conclusions where they suggested that companies should be highly geared because of the measurable tax benefit (Modigliani & Millar, 1963). Therefore as the companies gearing increased, the WACC would decrease due to the tax benefit of debt. This would suggest that Det Norske should scrap the idea of raising finance through equity, load-up heavily on debt which would result in WACC being at its lowest and company value at its highest. Therefore, the theory now suggested that in fact there was an optimal capital structure - being highly geared. Clearly I would not recommend this for Det Norske or any company as it does not take into account the risk of financial distress which in reality does exist and will have a negative effect on a company’s value. By heavily increasing debt levels shareholders will demand higher returns to compensate for the risks they are taking, lenders will require higher interest rates and it is highly unlikely that potential investors will be attracted to the business.

To conclude, I personally believe that an optimal capital structure does exist as it seems logical that there becomes a point where having too much debt causes the cost of equity to increase as shareholders become worried. I also believe that when a company achieves such a structure it will increase shareholder wealth as they are able to broaden their strategic option set, thus increasing their scope for investments. In addition, I take the view that there is no generic ideal combination of the structure but that this varies depending on the company, the industry and the economic climate. It is impossible for me to predict what decisions Det Norske will make in terms of their capital structure but I think it is crucial they consider the benefits and drawbacks of both equity and debt finance as well as the business risks they are currently facing and how shareholders will react to the decisions they make. It will be interesting to see what decisions they make and whether they believe they were able to achieve their optimal capital structure.

References

Arnold, G. (2012). Corporate financial management. New York: Pearson.

Bloomberg (2015). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved 3^rd March 2015 from http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

Brusov, P., Filatova, T., Orehova, N. & Brusova, N. (2011). Weighted average cost of capital in the theory of modigliani-miller, modified for a finite lifetime company. Applied Financial Economics, 21(11), 815-824. doi:10.1080/09603107.2010.537635

Modigliani, F. & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297. Retrieved from http://search.proquest.com/?accountid=12860

Modigliani, F. & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. The American Economic Review, 53(3), 433-443. Retrieved from http://www.jstor.org/

Reilly, R. R. & Wecker, W. E. (1973). On the weighted average cost of capital. Journal of Financial and Quantitative Analysis, 8(1), 123-126. doi:10.2307/2329754

Watson, D. & Head, A. (2013). Corporate finance: Principles and practice. New York: Pearson.