A Hard Balance

I have found Capital Structure and the concept of trying to optimise the WACC (weighted average cost of capital) quite hard to get to grips with. From what I understand, it is basically about trying to manage the amount of debt vs equity a company has to ensure it can make profit and continue with projects in order to grow; and of course try to reach the optimal WACC figure. It can be seen all the time, currently, Hilton hotels are going to 'spin-off' 70 of their hotels into separate company 'Hilton Grand Vacations' as it will allow Hilton "to have capital structure better suited to their needs" (FT, 2016).


There is a lot of debate as to which is best and if an optimal structure exists. If I was the CEO of a company and followed Modigliani & Millar's (1958) ideas, I would chose debt over equity as the first port of call as it is cheaper and that is surely a good thing, right? Cheaper capital equals more projects the company can undertake and better profit for the company due to less tax and transactional costs. They believed there was no impact on the WACC, so therefore as CEO I would go for debt over equity. A measurement of the debt/equity is the gearing ratio. I find the gearing ratio really useful when assessing the 'riskiness' of a company and have used it at work and in University when doing an assignment to conclude whether I would invest in a FTSE 350 company (the answer was no as their gearing was over 400%). In theory, the concept using gearing that I have learnt is the 'trade-off' model where you can have gearing up to an optimal point before problems will be seen. In the case of the FTSE 350 company I analysed, 400% was obviously over that threshold.


However, when you get your capital structure decisions wrong financial distress signals can be released, especially in the way of high debt and it will not only be the lenders who know you are in trouble. Shareholders will be aware that their share value may be destroyed through auditors giving a going concern report a long with the accounts. I was an auditor for a year during my university placement (exciting accountant I know) and we had to give going concern reports which made nobody want to invest in that company. This unfortunately will have stopped them from gaining investments they needed in order to expand and grow into new markets until they got their affairs sorted. Look at Areva in France (FT, 2016) currently, they delayed their results to try finalise a 1.1bn euro loan so their shareholders would not lose confidence. Now becoming 4 grades below investment grade status, Areva will find it hard for new investments. I touched on Anglo American mining in a previous blog, but they are a good example of what I am trying to explain. They have too much debt and now have junk bond status which will hold them back in the future (have they made wrong decisions on capital structure? Or is it industry factors?).


If I was the CEO of a company, I think it would be a really hard balancing act to make sure you always had an optimal level of debt to equity. I don't think there can be a theory that can be put for all companies to abide by and the level of debt vs equity that is optimal for one company will not be optimal for another company. I think that it really depends on the industry, the level of long-term debt in a pharmaceutical company would not be optimal for a company in the service industry.