Capital Structure Introduction Within the QP curriculum, capital structure is an important topic as it teaches evaluating the long-term financial management position of a business and deciding on sources of finance and funding methods. This article explains the key concepts of capital structure including leverage/gearing ratio and weighted average cost of capital (WACC). We will also discuss the applications of capital structure, including, capital allocation, dividend policy, financing strategy, target credit rating and capital planning. Finally, we will provide a case study to illustrate how corporate finance and treasury strategy can be used to optimize capital structure to achieve the right balance of profitability, risks and shareholder value. Key concepts Capital structure represents the proportion of financing provided by shareholders in the form of shareholders equity (or commonly referred to as equity) and creditors in the form liabilities (bank loans and bond investors). Together equity and liabilities provide the capital or funding to invest in assets that generate revenue to pay for finance cost (mandatory) and dividend (optional). The undistributed profit adds to retained earnings to further expand the equity. The relationship between balance sheet, income statement and cash flow statement relevant to capital structure is described in the following diagram:
To maximize return on capital (ROC), the cost of capital that needs to be minimized is commonly measured by computing the weighted average cost of capital (WACC). The relation between cost of equity and cost of debt is somewhat complex: Approach Cost of equity Cost of debt Conventional: Cost of equity and cost of debt have an inverse relation Normally during economic recovery periods, stock prices will go up due to improved earnings performance. Improved consumer affordability also encourages innovation with new products commanding an above average P/E ratio. Cost of equity is therefore attractive. Post-Global Financial Crisis (GFC) Both cost of equity and cost of debt have been attractive post- GFC but future outlook is uncertain During economic downturns, companies experience reduced earnings and can only afford to pay a lower dividend. Cost of equity is therefore expensive. Due to the need to safeguard the supply of liquidity and contain systemic risk, central banks implemented quantitative easing (government buying bonds held by the bank). This created asset inflation including rising share prices. Cost of equity is attractive. The dichotomy of economic development between the U.S. and the rest of the world creates much uncertainty in global stock markets. Depreciation of non-u.s. currencies may also affect investment sentiment in local stock markets. When aggregate demand exceeds the capacity of the economy, inflation pressure builds up and interest rates will go up. Therefore cost of debt is not attractive. Reduced demand for credit and lower inflation pressure will reduce interest rates. Cost of debt therefore becomes more attractive. For the same reason (quantitative easing), interest rates have been kept at historically low levels, making cost of debt also attractive. The normalization of U.S. interest rates will raise cost of debt. How local non-u.s. interest rates will respond depends on the flexibility of the exchange rate policy so the net effect is uncertain. The degree of leverage or gearing ratio will affect the cost of equity and cost of debt: High leverage Low leverage Cost of equity Low (due to higher return on equity/roe contributed by a larger asset base with same amount of equity) High (the reverse of the above argument) However there is an exception. A low leverage stock may be able to set aside a higher/more stable dividend. Therefore a high dividend stock may also command a stock price premium reducing the cost of equity. Cost of debt High (due to perceived risk of default and the required return to bond investors for the high risk premium) Low (the reverse of the above argument)
Application The applications of capital structure include: capital allocation, dividend policy, financing strategy, target credit rating and capital planning. Capital allocation (Investment decision) Dividend/share buyback policy Financing strategy Target credit rating Capital planning Performance management Application of capital structure As the return on capital must exceed the cost of capital to generate shareholder value, the capital structure through influencing the cost of capital also affects the decision on efficient capital allocation to different business units (BUs), products and markets. The cost of capital is commonly used as the discount rate to compute Net Present Value (NPV) in capital budgeting exercises. When return on capital is less than cost of capital, shareholders demand returns of cash in the form of dividends or share buybacks. As debt/equity increases, the firm may be forced to deleverage to maintain a stable capital structure. Some firms choose to spin off BUs to generate cash to improve the parent s equity position. Bank loans and corporate bonds are complimentary to each other. Bank loans can be in the form of an uncommitted or committed facility, which will be drawn down on a needed basis and is therefore more flexible. However a bank loan is floating rate based, subject to interest rates, and also of a shorter duration. The size of the loan depends on the number of banks willing to provide credit. Bonds can provide a larger funding size but may result in a negative carry if the full amount is not immediately used. The fixed rate is usually of a 3-15 year duration and helps issuers to stabilize long-term funding costs. A firm should consider a right balance between the two. In Asia, firms are historically over dependent on bank loans and expose themselves to refinancing risk (the ability to obtain renewed credit support from banks for the size and pricing of funding they require) and interest rate risk (during a rate hike at rollover time). A corporate bond program reduces refinancing risk by extending the maturity profile and provides better an ALM match against the cash flow pattern of underlying assets. It also has the following benefits: Access to a broader investor base Pricing estimate based on the credit risk premium (over risk free rate) of comparable bond issuers. This technique is a relative of value analysis. Access to foreign currency financing (with hedging ratio dependent on risk budget/tolerance) Unless the issuer is well known to investors, most often require a credit rating by international credit rating agencies (e.g. S&P, Moody s, Fitch) before corporate bond issuance. Capital structure is a key determining factor for the rating. Most firms aim to achieve a target credit rating to stabilize funding costs. In asset & liability management (ALM), the right mix of debt and equity is required to match the asset structure. For asset-intensive industries such as real estate, power, shipping/aircraft, a long payback requires debt with a longer maturity profile. For banks and financial institutions which are highly leveraged with a large ALM mismatch due to nature of their business (maturity transformation), capital structure requires a consideration of how liquidity risk is managed. Economic Value Added (EVA) as a performance measure incorporates WACC so the capital structure decision does matter. Chinese State-Owned Enterprises are required to adopt EVA.
Case study The application of capital structure can be illustrated using the example of Swire Pacific: Capital management Objective is to safeguard its ability to operate as a going concern, continue to provide returns for shareholders, and to secure access to financing at a reasonable cost Capital structure To achieve the target investment grade rating of single A (A3 to A1/Moody s, A- to A+/S&P, A- to A+/Fitch) Latest rating: (A3/Moody s, A-/S&P, A-/Fitch) Factors used in a. Gearing ratio (net debt/capital; net debt = total borrowings less cash) monitoring its capital b. Cash interest cover structure c. The return cycle of investments Weighted average Weighted average cost of debt = 4.1% or 3.9% (excluding perpetuals) cost of debt Weighted average term of debt = 4.1 years Cost of debt HKD: 0.88-2.70% for short term loans and 0.77-5.05% for long term loans and bonds USD: 1.48-2.80% for short term loans and 0.89-6.25% for long term loans and bonds, 8.84% for perpetuals RMB: 5.04% for short term loans and 3.90-6.77% for long term loans and bonds Return of equity 5% (Source: Swire Report 2014, data are 2014 unless otherwise stated) Illustration of the calculation of gearing and the sourcing of financing by business units (BUs): Net debt = total borrowings HK$68,788M cash $10,164M = $58,624M
Capital is at $262,130M, with a gearing ratio of $58,624M/$262,130M = 22.4% which is slightly higher than 19.2% in 2013 due to the increase in debt to fund capex on property, new vessels and investments in subsidiary/jv. Conclusion Capital structure is a key aspect of financial management. The decision on capital structure will affect the cost of capital, the risk, and the profitability of the firm. It is complex because the decision is influenced by changes in market conditions that determine the behavior of equity and bond investors and how they perceive the BUs performance affecting their expected return from investment. About the author Peter Wong FCPA The author is a fellow member of the Institute since 1992. He was the President of CIMA Hong Kong in 1997 and the Chairman of the Hong Kong Association of Corporate Treasurers during 2000-2012. He is Founding Chairman of IACCT (China) established by HKACT in 2006 to promote treasury best practice in China. He has been appointed by the Hong Kong Monetary Authority as Board Member of the Treasury Markets Association since 2006 and a member of the Working Group on Corporate Treasury Development since 2012. He held positions of Director of Finance/Treasurer of one top 10 global shipping conglomerate for six years and the Regional Director and Treasurer of AIA/AIG for over 13 years. He is currently the Director of PwC Consulting specialized in treasury advisory practice in Greater China.