Capital Structure

Why this matters

Two companies with identical factories, customers, and profits can be very different investments if one is funded mostly by its owners and the other mostly by lenders. Is It Financially Strong? introduced the measures of borrowing. This lesson is about the choice behind them: why a company borrows at all, what that does to its shareholders, and how much is too much.

Two ways to fund a business

A company's capital structure is its mix of two kinds of money.

• Debt is a promise. Lenders get interest on a set schedule and their money back on a set date. They're paid before shareholders, and they get nothing extra if the company does well.
• Equity is ownership. Shareholders get whatever is left after everyone else is paid, which may be a great deal or nothing.

Because lenders are paid first and take less risk, they accept a lower return than shareholders require. US tax law adds to the gap: companies can generally deduct interest from their taxable income, within limits, while payments to shareholders aren't deductible.¹ So debt appears to be the cheaper source of money. The question is why companies don't use far more of it.

What borrowing does to shareholders

	Good year	Normal year	Bad year
Operating income	150	100	40
Company A: $1,000 of equity, no debt
Net income, after 21% tax	118.5	79.0	31.6
Return on equity	11.9%	7.9%	3.2%
Company B: $500 of equity, $500 of debt at 6%
Interest	(30)	(30)	(30)
Net income, after 21% tax	94.8	55.3	7.9
Return on equity	19.0%	11.1%	1.6%

The businesses are identical. In a normal year, Company B's shareholders earn 11.1% where Company A's earn 7.9%, because half the money was borrowed at 6% and put to work earning 10% before tax. In a good year the gap widens. In a bad year it reverses: Company B's return falls to 1.6%, below Company A's 3.2%. If operating income fell to $20 million, Company A would still earn a small profit, and Company B couldn't cover its interest.

That's leverage. It doesn't change how good the business is. It makes the shareholders' outcome more extreme in both directions, and it puts a floor under how bad a year the company can survive.

Why the mix matters less than it seems

It's tempting to conclude that Company B is the better investment, since its normal return is higher. That misses half the picture. Company B's shares are riskier, so its shareholders should require a higher return, and a higher required return means a lower price for each dollar of earnings.

Franco Modigliani and Merton Miller showed that in a simplified, idealized model of financial markets, the two effects cancel exactly. The choice between equity financing and borrowing doesn't affect a company's market value or its average cost of capital, and the return shareholders expect rises in step with the ratio of debt to equity.² Swapping equity for cheaper debt makes the remaining equity more expensive by just enough to leave the total unchanged.

The real world departs from that in two ways that pull in opposite directions.

• Taxes favour debt. In the example, Company B pays $14.7 million of tax in a normal year and Company A pays $21 million. The $6.3 million difference is the 21% federal corporate tax rate³ applied to the $30 million of interest, and it goes to investors instead of the government.
• Financial trouble is expensive. A company that can't comfortably meet its debts loses more than the interest. Suppliers tighten terms, customers hesitate to rely on it, good staff leave, and management spends its time on lenders instead of the business. If it has to raise equity, it does so when its share price is lowest. If it goes into bankruptcy, shareholders are last in line, as Bankruptcy and Restructuring describes.

So a moderate amount of debt adds a little value through tax, and too much destroys far more through risk. There's no formula for the right level. There's a sensible range, and it depends on the business.

How much debt a business can carry

The same amount of borrowing can be prudent for one company and reckless for another.

Borrowing stacks on top of the business's own risk. A company with high fixed costs already has operating leverage. Adding heavy debt to it means two sets of fixed costs meeting the same fall in sales.

Reading a company's choice

STU Corp, the fictional company from Part 3, sits at the cautious end. It has $90 million of debt and $60 million of cash, so its net debt is $30 million against operating income of $80 million. Its interest of $6 million is covered more than 13 times.

Suppose it borrowed another $310 million at 6% and used it to buy back shares. Interest would rise to about $25 million, and cover would fall to roughly 3 times. Earnings per share would probably rise, because there would be fewer shares. The business wouldn't have improved at all. It would simply be less able to absorb a bad year. Whether that's a good trade depends on how steady its cartridge sales really are, which is a judgment about the business, not about finance.

When looking at any company's borrowing, check:

• Debt against cash profit, and interest cover, in a weak year as well as the latest one.
• When the debt falls due. A large repayment in the next two years has to be refinanced at whatever rates and conditions apply then.
• Fixed or floating rates. Floating-rate debt becomes more expensive when interest rates rise.
• Obligations outside the debt line, such as leases and pension shortfalls, which the first track in this series covered.
• Why it changed. Debt taken on to build something that will earn more than it costs is different from debt taken on to buy back shares at a high price or to keep paying a dividend the business can't afford.

Key takeaways

• Debt is cheaper than equity because lenders are paid first and interest is generally deductible.
• Borrowing raises the return on equity in good years and cuts it in bad ones, and makes the shares riskier.
• In theory the mix doesn't change a company's value. In practice taxes add a little and the risk of financial trouble can take away a lot.
• Steady businesses with tangible assets can carry more debt than cyclical, young, or asset-light ones.
• Judge borrowing by whether the company could carry it through a bad stretch.

Check your understanding

A company replaces half its equity with debt. Its operating income is unchanged, and its return on equity rises from 9% to 14%. What has happened to the business?

1. It has become more profitable, since each dollar of equity now earns much more.
2. Nothing. The same profit is shared among less equity, which now carries more risk.
3. It has become safer, since lenders only lend to companies they judge to be sound.

Which company is best placed to carry a high level of debt?

1. A young biotechnology company with one drug in trials and no revenue yet.
2. A maker of construction equipment whose sales halve in each recession.
3. A regulated water utility with steady demand and long-lived physical assets.

What's next

This lesson treated the cost of debt and equity as given. Cost of Capital in Depth looks at where those numbers come from and how much they can be trusted.