The Importance of Capital Structure — June 2016

This topic involves Treasury.

As we have discussed in the past, Treasury efforts ensure the company has the liquidity necessary to function profitability, minimize the costs of financial transactions, and utilize the company’s cash in the most efficient manner practical. Other important Treasury functions include raising capital and the long term funding process. The CFO has a vital role in these matters.

Raising capital and long term financing involves having permanent capital, long term debt and equity, in place to ensure a stable platform for profitable growth. The key element that facilitates this process is determination of the optimal capital structure from which the company’s mix of debt and equity is resolved.. Once this is accomplished, the CFO must raise capital from a variety of sources while maintaining the target blend of debt and equity.

The primary goal of the business owner is to maximize the value of the company. This value is driven by two factors. First, there is the ability of the firm’s assets to generate cash flow. Second, is minimizing the firm’s cost of capital by developing the appropriate capital structure.

Capital structure is the company’s mix of financing methods. It is characterized by a trade off between risk and return. More debt in the capital structure lowers the cost of capital, thus increasing the return to shareholders. On the other hand, it increases the risk of default since it reduces the margin of error in the firm’s ability to service the debt’s fixed charges.

Accordingly, the firm’s goal is to achieve an optimal capital structure so that an increase in the percentage of debt to the point where the benefit from the next dollar of debt financing is equal to the risk of bankruptcy from the next dollar of debt financing. Any percentage of debt that is higher increases the risk, without a commensurate return for shareholders. Management’s application of this principle will result in the company’s target capital structure. This structure will minimize the firm’s risk adjusted cost of capital.

Factors the CFO must consider in helping management determine the target structure are four fold. One is the ability to service debt. Second the ability to use tax shields fully. Next is the ability of assets to support the debt. Finally, the CFO must consider the desired degree of access to the capital markets.

The ability to service debt means the company must be able to make contractually required payments, even under adverse conditions. Accordingly, a greater proportion of debt financing entails more risk.

The ability of the firm to use interest rate tax shields means the company must generate sufficient cash flow to claim full deductions for the cost of interest. This tax advantage is not available for equity distributions, hence debt’s lower cost of capital.

The ability of the firm’s assets to support the debt is the certainty, timing, and amount of cash flow generated by the firm’s assets relative to the company’s ability to make the timely contractual payments required by debt. Lower risk assets with stable market values and predictable cash flow streams are less risky and provide collateral if the bank requires it. All else equal, the debt will be less costly.

The desired degree of access to the capital markets is critical for a dynamic, growing small business. Such a firm will require continual access to capital on acceptable terms. This condition will facilitate the funding of growth opportunities.

When the target capital structure is determined, the CFO must cultivate an array of financing sources and raise the funds on a timely basis while achieving the target blend of debt and equity financing. Accomplishing this feat will maximize the firm’s value.

A major function of the firm’s Treasury effort is raising capital and the long term funding process. The CFO has a vital role in these matters. Raising capital and long term financing involves having permanent capital, long term debt and equity, in place to ensure a stable platform for profitable growth. The key element that facilitates this process is determination of the optimal capital structure from which the company’s long term capital structure is developed. Once this is accomplished, the CFO must raise capital from a variety of sources while maintaining the target blend of debt and equity

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