Enabling Capital Structure To Support Global Strategy

By M. Isi Eromosele

A company’s ratio to debt equity must support its business strategy and should not be used to pursue tax breaks.

When a company has a bad capital structure, this represents a potential harm to its operations and business strategy. Rather than rely on capital structure to create value on its own, companies must closely align it with their global business strategy by striking a balance between tax savings that debt can deliver and the greater flexibility of equity. Companies are capable of creating more value through making their operations highly efficient rather than relying on creative financing.

Impact Of A Reliable Capital Structure

A company’s overall value is affected by its capital structure through the impact it has on the firm’s operating cash flows and cost of capital. In most countries, the expense of paying interest on debt is tax deductible. As such, a company may reduce its after-tax cost of capital by increasing debt relative to its equity, facilitating a rise in its inherent value. It is a fact that the value of tax benefits is relatively small over the relevant levels of interest coverage.

The consequence of accumulative debt on a company’s cash flow is of a smaller amount but more significant. Carrying debt usually increases a company’s relative value because debt inflicts discipline that requires a company to make recurring interest and principal payments. If a company accumulates too much debt, its relative value is reduced, which in turn limits its flexibility to make value-creating investments, including capital expenditures and acquisitions, as well as spend on other business intangibles such as Research & Development, sales and marketing.

Proper management of capital structure requires a company to make a trade-off between financial flexibility and fiscal discipline. Mature companies with steady and predictable cash flow should include more debt in their capital structure. Companies that face high levels of uncertainty should carry less debt, which would give them more flexibility to exploit investment opportunities.

When a company’s share is under- or overvalued, they could use the company’s underpinning capital structure to create value, either by buying back undervalued shares or by using overvalued shares instead of cash to pay for acquisitions.

Framework For Developing Capital Structure

To develop its capital structure, a company must recognize its future revenues and investment requirements. Once these fundamentals are understood, the company can then begin to consider changing its capital structure to support its global business strategy. The company’s decision making process could include the following steps:

• Estimate its financing deficit or surplus. They will need to forecast the company’s financing deficit or surplus from its operations and strategic investments over the course of its business cycle.
• Set a target credit rating. Set a target credit rating and estimate the corresponding capital structure ratios. Then they could translate the target credit rating to a target interest coverage ratio.
• Develop a target debt level over the business cycle. Set a financing debt cushion of spare debt capacity for contingencies and unforeseen events.
• Test this forecast against a downside scenario. Arrive at an acceptable target debt level which allows the company to maintain an investment-grade rating under the downside scenario

The final step in this approach is to determine how the company should move to the target capital structure. This transition involves deciding on the appropriate mix of new borrowing, debt payment, dividends, share repurchases and share issuances over the next few years.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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