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.