Assessed Blog 2: What is the Optimal Capital Structure?

The capital structure of a company is the composition of debt and equity used by the company to finance its assets (ACCA, 2009). This financing decision is a key concern for the CFO’s and leadership of firms as the capital structure of the firm can be used to create wealth for shareholders. Shareholder wealth can be achieved by creating a capital structure that decreases the Weighted Average Cost of Capital (WACC) of the firm, thus enhancing the value of the company, increasing shareholder wealth (Arnold, 2013). But what is the optimal capital structure?

British-Australian mining company, Rio Tinto, had a gearing level of 130% in 2008. However, today it has a much more conservative level of debt at around 20% (Armitage, 2014). This article will look to explain why Rio Tinto has chosen on such an enormous shift in their capital structure, and how this links to the theories covering capital structure.


In 1958, Modigliani and Miller proposed that the debt/equity level of the firm will have no impact on the value of the firm or the firm’s ability to create shareholder wealth. This argument was made considering a perfect capital market and no taxation. They argued that the level of WACC will be unchanged, as the decrease in WACC from increasing debt finance will be offset by the increase in the cost of equity caused by greater financial risk. Following heavy criticism from fellow scholars, Modigliani and Miller revised their theory to include the effect of taxation. They then found that capital raised through debt was cheaper due to tax relief, therefore they encouraged firms to maximise the amount of gearing to reduce the WACC (Modigliani and Miller, 1963).


So why do firms not become fully debt-financed? The cost of debt from lenders tends to be cheaper than the cost of equity (which comes from the required rate of return demanded by investors). However, despite initially decreasing the WACC of the firm, it has been found that increasing gearing increases the financial distress costs associated with the increased risk that debt brings. For the increased risk, equity holders demand greater returns, thus offsetting the reduction of WACC from increasing the debt finance.

Average gearing levels varies from industry to industry. Firms with reliable forecasts are better positioned to become highly geared, as there is confidence from the market that future cash flows will be achieved, and the firm will be able to service their debts (Grant, 2009). Rio Tinto had high gearing levels during a boom period for the mining industry where regular cash inflows were to be expected. The finance was used to fuel the company’s ambitious expansion plans, however, the market experienced a fall in demand and prices (Armitage, 2014).

The decline in the market has had an impact on many mining firms, and the leadership of Rio Tinto has had to reassess their capital structure. In 2013, the company was warned by credit rating agency Standard and Poor’s that their single A credit rating could be downgraded if their debt position did not improve (Financial Times, 2013). With $33bn debt in 2013, the company has since looked to reduce its debt by selling off assets and cutting costs. As well as reducing their gearing level, Rio Tinto has increased its equity capital base. Is this a positive move?


From selling off areas of the business (including their Mozambique coal assets), cutting 2,200 jobs, and only focussing investment in profitable mines, Rio Tinto reduced their net debt position by $6bn. As well as reducing their financial risk, Rio Tinto has improved their profit margins, also factoring in to their improved share price (BBC, 2014).


This case of Rio Tinto shows that Modiglinani and Miller’s (1963) proposition fails to acknowledge the risk of financial distress which is attached to increasing gearing levels. Much of the literature since Modiglinani and Miller, have discussed how the rise in financial distress costs eventually outweighs the benefit of the lower cost of debt (Arnold, 2013; Stern, 1998). In conclusion, the literature, theory and consideration of real-life businesses would suggest that there is no set optimal capital structure. Instead the capital structure of companies is likely to be dynamic, and will be dependent on the business environment that it finds itself in, as well as the current state of the firm’s operations.

 From my knowledge of capital structure, I understand that the mix of debt and equity can be used by a firm to support strategies for creating shareholder wealth. By finding the level of debt, that finds the optimal balance between the trade-offs of lower cost of capital and costs of financial distress, companies like Rio Tinto can further increase their cash flows. From lowering the WACC of the company, more projects will result in postive NPVs - creating more wealth.

References

ACCA (2009). Optimum Capital Structure. Retrieved from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_junjul09_lynch.pdf


Armitage, J.. (2014). Rio Tinto chips $6bn off its debt mountain. Retrieved from http://www.independent.co.uk/news/business/news/rio-tinto-chips-6bn-off-its-debt-mountain-9655837.html


BBC (2014). Rio Tinto profits rise as debt and costs are lowered. Retrieved from http://www.bbc.co.uk/news/business-28685501
Grant (2009). Gearing Levels set to plummet. Retrieved from http://www.ft.com/cms/s/0/121f9a34-f7b5-11dd-a284-000077b07658.html#axzz3TbRcXbvo


Hume, N. (2013). Rio Tinto warned of a possible rating cut. Retrieved from http://www.ft.com/cms/s/0/279caad2-7fc9-11e2-8d96-00144feabdc0.html#axzz3TbRcXbvo

Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment American Economic Review, 48(3), 261.

Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction. The American economic review, 433-443.


The Economist (2014). Share Buy Backs – The Repurchase Revolution. http://www.economist.com/news/business/21616968-companies-have-been-gobbling-up-their-own-shares-exceptional-rate-there-are-good-reasons


Titman, S., & Wessels, R. (1988). The determinants of capital structure choice. The Journal of finance, 43(1), 1-19.

Assessed Blog 1: Shareholder Value Destroyer to Creator: Hewlett Packard

Are managers too obsessed with growth? Do companies who focus on increasing short-term earnings truly maximise the wealth of their shareholders?

The case of Hewlett-Packard (HP) shows how shareholder wealth can be destroyed without effective value-based management. Despite having the intentions to increase shareholder wealth, poor strategic decision making actually led to shareholder wealth destruction.

In 2002, in a bid to improve profitability, HP outsourced the manufacturing of their computers. Despite achieving lower unit costs, and investing greater in their supply chain, product development, and customer relationship management, the company suffered from a fragmented supply chain in the long-term (Mourdoukoutas, 2014). From overly-focussing on improving bottom line figures, this allowed for competitors to enter the market easily resulting in a loss of market share and sales revenue for HP (thus destroying shareholder value). This is a clear example of how focussing on profit maximisation does not necessarily improve shareholder wealth (Arnold, 2013. John Kay's views portrayed through his book 'Obliquity' (2011)closely apply to this case. He argued that profits should not be made to be the sole purpose of the business, but rather that profits are a result of applyging passion and investment in to the business' core activity. HP made the strategic decision to increase profits without analysing the wider impacts from the decision.

Rappaport (2006) states that acquisitions can create or destroy shareholder value quicker than any other corporate activity. Over the past 10 years, HP also acquired a number of companies as part of its strategic direction for growth. However, these acquisitions failed to attain growth and increase shareholder wealth. Compaq, Palm and Autonomy were all bought to enhance HP's competitiveness in growing market segments such as the mobile device market, and the emerging Asian markets. However, little innovation was created, and HP failed to make up ground, eventually writing down these companies for huge billion dollar losses (Financial Times, 2014). 

A possible reason for this failure, may be that HP's management failed to appropriately evaluate measures of P/E and EPS to evaluate the attractiveness of the deals. It is likely that managers approved deals that resulted in a greater EPS post-acquisition, rather than evaluating the long-term potential to create value (Rappaport, 2006). This should be done by estimating the present value of the resulting incremental cash flows and then deducting the acquisition fee (Seth, 1990). Dane Anderson (IT Outsourcing Analyst) concluded "HP seem to say, this looks good, lets buy it because we can buy it and we'll figure out what to do with it later" (Financial Times, 2014). This insight clearly shows that there was a lack of financial reasoning and considered value management involved in the process of the acquisitions made by HP. Had the company assessed the potential synergies more clearly then they could have calculated future cash flows of the joint entitites to assess whether the purchases were financially viable.

However, the strategic decisions of HP for various reasons were misinformed. Positive NPVs projects were not achieved and inefficiencies across the business meant that shareholder wealth was thus destroyed.

Following years of declining performance and share price, HP were one of the best performing stocks on the S&P 500 in 2014 (Mourdoukatas, 2014). New CEO, Meg Whitman, has proposed a new
strategy to break the business up in to two areas (Personal computing and printing division, and software and corporate hardware divisions) (Rushe, 2014). This decision will actually decrease HP's revenue at the expense of increasing their profit margins (Mourdoukatas, 2014). These changes will allow each division to strengthen their core business and become more flexible and responsive to the dynamic markets that they compete in. This strategic move has been praised by investors and the announcement of the restructure resulted in an increase in share price of almost 5% (Financial Times, 2014).  Activist investor Ralph Whitworth praised the deal as a "brilliant value-enhancing move" (Rushe, 2014).

Perhaps HP have learnt their lesson and have decided to better use value management tools to guide their strategic decision making and direction. Value based management holds the primary purpose of "long-term shareholder wealth maximisation" (Arnold, 2013). The objective of the firm, its systems, strategy, processes, analytical techniques, performance measurements, and culture, have as their guiding objective shareholder wealth maximisation. I believe that with the new leadership in the company, the strategic decision making has become increasingly focussed on creating sustainable long-term value with less emphasis on short-term revenue growth.

References

Arnold, G. (2013). Corporate Financial Management.(5th ed.). London:Pearson Education

Financial Times (2014). HP counts cost of ill-fated acquisitions. Retrieved 14th February 2015 from
http://www.ft.com/cms/s/0/b5ba407a-e2be-11e1-a463-00144feab49a.html#axzz3RXk8eRDm

Mourdoukoutas, P. HP's split: A sound strategy or a rabbit pulled out of a hat? Retrieved 14th February 2015 from http://www.forbes.com/sites/panosmourdoukoutas/2014/10/07/hps-split-a-sound-strategy-or-a-rabbit-pulled-out-of-a-hat/

Rappaport, A. (2006). Ten Ways to Create Shareholder Value, Harvard Business Review, 84 (9), pp. 66-77. Retrieved 14th February 2015 from http://cmsu2.ucmo.edu/public/classes/young/Guidance%20Research/Ten_ways_to_create_sharholders_value-Alfred_Rappaport.pdf

Rushe, D. (2014). Hewlett-Packard announces plans to split company in two as lay-offs continue. Retrieved from

http://www.theguardian.com/business/2014/oct/06/hewlett-packard-split-two-data-printers

Seth, A. (1990). Value creation in acquisitions: A re-examination of performance issues. Strategic Management Journal, 11 (2), 99-115. Retrieved 14th February 2015 from Wiley Online Library DOI: 10.1002/smj.4250110203