Corporate Financial Strategy
Arindam Bandopadhyaya, Kristen Callahan, and Yong-Chul Shin
The growth of a business depends on many factors. Strong leadership is essential, product demand is critical, and careful financial planning is imperative. In today's economic environment, it is more important than ever for organizations to examine both assets and liabilities, incorporate budget details into a feasible plan, choose the right investments, understand their financial implications, and validate their return. According to the senior vice president at Ventana Research, "An organization's financial planning process must provide executives and management across the entire organization with the ability to plan investments and budgets that fit their corporate strategy. Moreover, it's just as important that they are able to change these plans and budgets quickly and easily to adapt when business conditions change."1 Although there are many aspects to sound corporate financial planning, much of the research and conversation in the past five years has been on issues related to sources of capital. In particular, discussion has focused on the following:
1. Questions about the existence of target debt-to-equity ratio, the so-called capital structure of a firm, and the behavior of managers toward readjusting when capital structure diverges from the target.
For example, do firm managers have a debt-to-equity ratio that they would like to obtain, and do they take action when the actual and target ratios differ?
2. Identifying what factors influence the selection of a capital structure. For example, is there a relationship between capital structure and (a) market-timing behavior, (b) macroeconomic conditions and business cycles, and (c) behavioral characteristics of managers?
3. Evaluating what the relative advantages and disadvantages of debt and equity financing are. For example, what is the value of additional debt? Although the addition of debt increases the tax advantage to firms resulting from the interest tax shield, it also increases the risk of bankruptcy and the likelihood of incurring associated costs. Does the value of the interest tax shield compensate for the increase in the default costs of debt? If there is indeed an optimal capital structure, a debt-to-equity ratio at which the cost of additional debt exactly offsets the marginal advantage, what are the costs of operating under suboptimal capital structures?
4. The identification of the optimal capital structure such that benefits and costs are balanced. For example, if the benefits and costs of debt can be measured, can an optimal capital structure be identified?
5. Financial flexibility and off-balance sheet financing tools such as leases, pensions, and Special Purpose Entities (SPEs). For example, are there benefits and costs associated with raising capital using these alternative methods and institutions?
The first part of the chapter examines these issues in detail. We begin with a brief description of traditional theories on the choice between issuing debt or equity to raise capital. The two dominant schools of thought on the question of capital structure, the Miller and Modigliani propositions and the pecking-order theory are discussed, and traditional empirical evidence regarding these theories is presented. Recent literature suggests the following:
1. Firm characteristics play a role in the choice of capital structure. For example, firms with high market-to-book ratios and high stock returns issue low levels of debt, whereas firms with significant tangible assets issue high levels of debt.
2. Macroeconomic conditions have an effect on the choice of capital structure. Debt levels tend to be high when long-term interest rates are perceived to be relatively low. They are also higher during boom periods than during periods of economic contraction.
3. Capital structure seems to persist over years. Firms with high debt-to-equity ratios in previous years tend to continue to be highly leveraged in subsequent years.
4. The characteristics of the CEO play a critical role in the firm's capital structure. CEOs with a military background issue more debt, those who have experienced a market downturn as well as female CEOs issue less debt, overconfident managers have an aversion to equity, and black-owned businesses find it difficult to find external funding of any kind.
5. Although firms may use less debt than is optimal, this is probably because the cost of taking on too much debt is higher than the cost of taking on too little debt.
The chapter also addresses issues related to the accurate calculation of the cost to the firm of raising capital, the so-called weighted average cost of capital (WACC). It is critical that the firm accurately determines the WACC, as underestimation will result in the acceptance of unworthy projects, and an overestimate will lead to the rejection of profitable projects. Discussion of capital structure relates closely to the issue of accurately calculating the WACC. Ultimately, the optimal capital structure is one that minimizes the WACC. However, once a firm determines its capital structure, the precise calculation of the WACC requires the correct determination of the cost of issuing debt and equity. A study of the literature, including survey-based studies, related to the calculation of the cost of issuing debt and equity indicates the following:
1. The capital asset pricing model (CAPM) is the dominant measure of the cost of issuing equity.
2. The risk-free rate is an important parameter in the CAPM. The interest rate on treasuries with maturities of 10 years or longer is typically used as the risk-free rate.
3. The CAPM requires an estimate of the rate of return of the market. Different measures are used as proxies for the market, but the New York composite index and the S&P500 index are the most commonly used.
4. The extent to which the firm's equity return is related to market return is measured by the beta coefficient of the firm. Accurate estimates of beta are central to obtaining precise estimates of the firm's cost of equity. Estimates of beta are sensitive to the length of time chosen for estimation purposes, and to whether daily or monthly rates are used to calculate the rate of return.
5. The difference between the expected rate of return of the market and the risk-free rate is known as the market risk premium. Surveys find large variance in the market risk premium used by managers (4%-6%) and analysts (7%-7.4%).
6. Market conditions have little effect on the cost of equity.
7. Firms use marginal cost when calculating the pretax cost of debt; for new bond issues, the yield to maturity on bonds with equivalent ratings is utilized.
8. Firms use marginal or statutory rates to calculate the tax benefit of issuing debt.
After calculating the costs of raising debt and equity, a firm needs to use appropriate weights, the so-called capital structure weights, to calculate the WACC. The chapter concludes with a discussion of how capital structure weights are selected. The weight for equity is observable since the market value of equity is known. The weight for debt is more difficult to observe, especially if the debt is traded in a thin, illiquid market. Recently, some firms have used off-balance sheet instruments such as leases and SPEs to raise capital. These instruments are outlined in some detail, and the implications for calculating the appropriate weights are discussed.