Managing capital structure thus becomes a balancing act. In our view, the trade-off a company makes between financial flexibility and fiscal discipline is the most important consideration in determining its capital structure and far outweighs any tax benefits, which are negligible for most large companies unless they have extremely low debt.
Mature companies with stable and predictable cash flows as well as limited investment opportunities should include more debt in their capital structure, since the discipline that debt often brings outweighs the need for flexibility. Companies that face high uncertainty because of vigorous growth or the cyclical nature of their industries should carry less debt, so that they have enough flexibility to take advantage of investment opportunities or to deal with negative events.
Not that a company’s underlying capital structure never creates intrinsic value; sometimes it does. When executives have good reason to believe that a company’s shares are under- or overvalued, for example, they might change the company’s underlying capital structure to create value either by buying back undervalued shares or by using overvalued shares instead of cash to pay for acquisitions.
Other examples can be found in cyclical industries, such as commodity chemicals, where investment spending typically follows profits. Companies invest in new manufacturing capacity when their profits are high and they have cash. Unfortunately, the chemical industry’s historical pattern has been that all players invest at the same time, which leads to excess capacity when all of the plants come on line simultaneously. Over the cycle, a company could earn substantially more than its competitors if it developed a countercyclical strategic capital structure and maintained less debt than might otherwise be optimal. During bad times, it would then have the ability to make investments when its competitors couldn’t.
A Practical Framework for Developing Capital Structure
A company can’t develop its capital structure without understanding its future revenues and investment requirements. Once those prerequisites are in place, it can begin to consider changing its capital structure in ways that support the broader strategy. A systematic approach can pull together steps that many companies already take, along with some more novel ones.
The case of one global consumer product business is illustrative. Growth at this company (we’ll call it Consumerco) has been modest. Excluding the effect of acquisitions and currency movements, its revenues have grown by about 5 percent a year over the past five years. Acquisitions added a further 7 percent annually, and the operating profit margin has been stable at around 14 percent. Traditionally, Consumerco held little debt: until 2001, its debt to enterprise value was less than 10 percent. In recent years, however, the company increased its debt levels to around 25 percent of its total enterprise value in order to pay for acquisitions. Once they were complete, management had to decide whether to use the company’s cash flows, over the next several years, to restore its previous low levels of debt or to return cash to its shareholders and hold debt stable at the higher level. The company’s decision-making process included the following steps.