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Optimal Capital Structures Corporate financial management Corporate finance Optimal capital structures FOR ANY COMPANY, THE OPTIMAL CAPITAL STRUCTURE IS A MOVING TARGET, SO REGULAR REVIEWS OF THE CAPITAL STRUCTURE ARE VITAL TO ENSURE THAT BUSINESSES ARE ABLE TO EFFICIENTLY DEPLOY THEIR STRATEGY AND GROW SUSTAINABLY, AS CHRISTIAN LEIBL AND YURI POLYAKOV EXPLAIN Much has been written to start by asking a simple about the abundance of question around objectives: cash sitting on corporate what is it that you want to balance sheets in recent years. solve? Being realistic and But as the global economy open in answering this continues to recover, the question – regardless of pressure on corporates to whether the company is maintain precautionary looking to reduce its cost liquidity is decreasing. In fact, of capital or simply to with activist shareholders maintain a conservative demanding that accumulated financial profile – is the cash be put to use, the new only way to achieve a capital challenge for treasurers is structure that is fit for to ensure that the company’s purpose at that time. capital structure ensures With the objectives sufficient flexibility for identified, it is worth taking current (and expected future) the time to carefully consider economic conditions – rather what needs to be optimised than focusing on those in the company’s existing experienced during previous capital structure, and what financial crises. is sustainable about it. During Against this backdrop, this process, it can be useful now is an opportune time to to keep in mind some guiding reconsider what the optimal principles around what an capital structure should be. optimal capital structure Finding the right balance should deliver: between cash, debt and equity funding is both an Optimal capital structure: art and a science, since an guiding principles optimal capital structure is 1. Efficiency. Debt is always a dynamic concept that shifts cheaper than equity and as the economic environment the capital structure should changes. Moreover, it is therefore include as much unique to each company debt as the company is – optimal means different willing to afford, based things to different issuers, on future cash flows. It is varying in line with specific important to recognise here operational or strategic that affordability may be contexts, as well as industry limited by industry sector. sector characteristics and Companies in industries management objectives. with stable cash flows, As such, while textbooks where the predictability might, from the outset, of their cash generation is suggest defining a company’s It is worth taking the time to consider high, will inevitably be able optimal capital structure in what needs to be optimised in the to afford more than those terms of the lowest weighted in volatile industry sectors. average cost of capital, it is company’s existing capital structure, 2. Flexibility. When actually far more practical and what is sustainable about it thinking about the optimal SOURCE IMAGE 30 The Treasurer October 2015 www.treasurers.org/thetreasurer capital structure and a funding strategy-driven risks (including industry- adequate headroom – or to affordability levels, it is necessity. While that is specific characteristics, maximise efficiency? vital to leave headroom absolutely the company’s for example, change in Stress-testing also provides to absorb the impact of prerogative, it is important to competitive dynamics), as an opportunity to consider any unwanted internal or formally recognise this when well as the macroeconomic how the optimal capital external events – such as setting the parameters of the environment. The treasurer’s structure will tally with the operational challenges or optimal capital structure. strategic business partners, company’s risk management changes in interest rates After all, credit ratings such as relationship banks, strategy, and vice versa. How – on cash flows and profit can open doors to investors’ will be able to assist in can the treasurer better margins. This provides a money. While investment- building this out. manage any of the scenario safety barrier that is more grade companies generally From those future cash stresses in order to increase efficient than holding find good market access flows, it is then possible to cash-flow visibility and a stockpile of cash. through the cycle, being determine how much debt reduce cash-flow volatility, for 3. Liquidity. Given the sub-investment grade does the company could, in theory, example? Treasurers should uncertain world in which not preclude an issuer from afford and, in turn, how much also take into account how treasurers operate, it finding liquidity. The size equity should be in place. risk management techniques is important to ensure of the debt financing that Once the base case is may impact the optimal that the company can the company needs to raise determined, it is advisable capital structure. tap different markets for and the market conditions to test its resilience using liquidity as and when at the time of issuance also scenario analyses. This Time to review required. Having access to play an important role. means stress-testing key Once all of these a broad funding toolkit will Over time, many companies cash-flow drivers, such as considerations have been assist greatly in achieving have successfully tapped operating profits, interest factored in, the treasurer the optimal capital alternative funding sources, rates, FX rates, working can set about implementing structure and, indeed, for such as private placements, capital, capital investments the capital structure that adjusting it over time. In unrated bonds and loans, as and other growth initiatives has been determined as addition, the broader the well as hybrid instruments. – which can be impacted by optimal. But part of taking access to liquidity, the more Moreover, it is not only the business or financial market a forward-looking view also means recognising that this is a moving concept – With so many considerations to take into account, and, as such, it needs to be how then can a company put all of this into practice monitored, reviewed and adjusted from time to time. to implement an optimal capital structure? A simple rule of thumb here is that if the company’s cash routes that are available financial profile or balance conditions. The key is to flows change by more than in the event a stress closes sheet structure of a particular stress-test for both in a way 10% from one year to the next, some routes to market. company that determines the that is consistent with the then it is time to revisit your quality of its credit profile; it specific challenges faced by capital structure and risk Conducting a thorough is the interplay between the the business. Take a Europe- management strategy. review of the company’s industry dynamics, business based airline business as And whenever you existing capital structure with model and balance sheet. an example. If there is a undertake this review, a view to optimising it also So while credit ratings are significant move in the £/$ regardless of the company’s means questioning the status important, they should not exchange rate, then not only credit rating or industry quo. Is a large cash buffer necessarily be perceived as will the jet fuel price change, sector, the guiding principles really required any more? the be-all and end-all. since commodities are priced should always be: efficiency, Is it in fact causing a drag in dollars, but customer flexibility and liquidity. on the efficiency of the A forward- demand characteristics are capital structure? looking approach likely to change accordingly. Another area where With so many considerations This means that a single corporates may want to do to take into account, how event in the FX market could some soul-searching is credit then can a company put have a double impact on ratings. For some companies, all of this into practice the business. one of the main objectives of to implement an optimal Taking into account all an optimal capital structure capital structure? the different risk factors that is to maintain a target credit The answer: by taking could affect the company’s Christian Leibl (left) is head of rating, which grants them a forward-looking view. profit margins and cash flows capital structure advisory; and Yuri Polyakov (right) is head of access to their optimal level of The first step here is to build in this way helps determine financial risk advisory at Lloyds capital market liquidity. For a base case for affordability, whether the proposed capital Banking Group other companies, though, the which means determining structure (resulting from credit-rating target is more the expected future cash the ‘affordability test’) is still of a cultural or philosophical flows of the company. This functional and affordable. level that the company likes should reflect the operating In other words, does the debt/ to maintain, rather than environment and business equity mix need to provide www.treasurers.org/thetreasurer October 2015 The Treasurer 31.
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