Capital structure: leverage and optimal capital structure

The capital structure is the type and weighting of the composition of the entire capital of a company from the various sources and types of capital, in particular from equity and debt capital. The capital structure is therefore the representation of the portfolio from the entered and current financial contracts, the capital portfolio of the company.
If only equity and a single form of debt are considered, the capital structure is often reduced to one number, the so-called leverage.

Debt ratio = debt capital / equity

The degree of indebtedness is mostly defined as the relation between debt and equity, but there is also a definition that defines the degree of debt as the quotient of debt and total capital (= sum of equity and debt). It should be added whether the two types of capital are expressed by their book values or by their market values.

The capital structure is the "opposite of" the corporate portfolio, which includes all asset positions. The capital structure is also a portfolio. A classic business question is what the “optimal” capital structure looks like. It is intuitively clear that the optimal capital structure must be determined simultaneously with the optimal structure of the company portfolio and cannot be designed in isolation from the company's assets. Every company in the financial sector (bank, insurance) has a sophisticated asset-liability management (ALM) for this. The assets form the company portfolio, the liabilities, together with the equity, form the capital portfolio.

Although the requirement of simultaneous planning of the company portfolio and the capital portfolio is intuitively understandable, it is naturally quite complex.
This explains the high level of attention that two American researchers, MODIGLIANI and MILLER, received around 1960 with their thesis that the capital structure is irrelevant for the value of the company. The premises for the Modigliani-Miller thesis call for a perfect financial market.

The equity providers should be able to bring about those financial measures that the management intends to take themselves and under the same conditions, and the equity providers should also be able to reverse the effect of a financial measure by the management through a differently directed financial transaction.

The premises for deriving the Modigliani-Miller thesis are:

1. The borrowing rate and is the same as the credit rate, and this rate is the same for all market participants (company, equity provider).

2. The investment amounts and loan amounts can be divided as required and there are no transaction costs

3. The tax legislation is financing-neutral.

4. An originally made premise regarding the risk of bankruptcy later turned out to be unnecessary.

Es muß nicht betont werden, daß diese Prämissen Idealisierungen sind. Die heutige Kapitalstrukturtheorie nimmt die genannten Prämissen und die Modigliani-Miller-These daher nur als Ausgangspunkt und konzentriert sich auf Abweichungen von diesem Bezugspunkt. Verschiedene Aussagen zur Bedeutung der financing mit Fremdkapital (Leverage-Politik) wurden erarbeitet. Die beiden wichtigsten sind:
1. If the taxes are not financing-neutral, the external financing has a positive effect on the value of the company (so-called tax shield).

2. Debt financing increases the risk of financial tightness and hardship (financial distress), because the debt must be served unconditionally as an obligation. Of course, this is especially true with high levels of outside financing.

These two arguments lead to the statement that the value of the (partly debt-financed) company would be equal to the value of the same company if it were only fully financed with equity, plus the present value of tax advantages, minus the present value of the disadvantages caused by a more likely financial distress .

Value with indebtedness = value without indebtedness + present value of tax advantages + present value of disadvantages increased financial distress

Further statements on the effect of external financing are:

Debt financing has a positive signal effect for the equity capital provider: The management is committed to overall sensible measures, which the debt capital providers (banks) pay attention to and which are therefore enforced in the case of external financing (without the owners having to make an effort):

1. Proper business plans.

2. An investment policy that allows you to pay interest with certainty.

3. A certain amount of transparency in the information.

4. In addition, banks contribute industry knowledge.

External financing, provided it is substantial, gives the company the opportunity to discuss a change of control from the owners to the creditors in the event of an emergency (financial distress). The financial options tend to be greater through the involvement of lenders.

Due to the limitation of liability, the value of the equity of an indebted company is convexly dependent (analogous to the payoff of a purchase option) on the development of the overall company value. As a result, equity providers are more willing to take risks, which in turn leads to the risk of a less transparent change in business plans in favor of riskier strategies (asset substitution effect).

The hope that the management is now aiming for a target structure that has been identified as “optimal” for the capital portfolio does not come true. Managers have a clear preference when it comes to raising capital. It is known as the financing pecking order. This pecking order is theoretically justified and empirically confirmed.

1. Das Management versucht in erster Linie das Potential an Internal financing für die Investitionen heranzuziehen. Die „Finanzierung aus eigener Kraft“ wird von ihnen lobend herausgestellt. Hier müssen, anders als bei der Außenfinanzierung, keine neuen Verträge abgeschlossen werden, und die Kontrolle der Mittelverwendung ist vielfach schwach.

2. Only when internal financing is insufficient do managers resort to external financing and conclude new financial contracts. The way to the bank seems easier to them than a capital increase.

3. Only when the bank does not give any more loans because the debt capacity has been reached, the managers take on the capital increase and approach equity providers.

In addition, managers tend to issue new shares when they think that share prices are currently rather too high. Investors see this behavior, and when a capital increase is announced, they react with sales given the assumed high prices. Raising new equity is expensive.

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