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Optimum capital structure

The issue of the optimal capital structure and subsequently the optimal mix of funding instruments is one of the key strategic decisions for a corporation. Our aim is to bring out the critical dimensions of this decision in so far as it involves international financing and examine the analytics of the cost-return tradeoff. The tangible realization of the chosen subsidy plan involves numerous other factors such as fulfilling all the regulatory necessities, selecting the correct timing and pricing of the issue, marketing of the issue and so forth. We only touch upon some of these issues.

The optimal capital structure for a firm or in other words, corporate debt policy has been a subject of a long running debate in the finance literature since the publication of the seminal paper by Modigliani and Miller in 1958. You can consult any one of a number of texts on corporate finance to get a flavor of this controversy. We assume here that the firm has somehow resolved the issue of what is the appropriate level of debt it should carry.


Next comes the issue of the optimal composition of a firm’s liability portfolio. The firm usually has a wide spectrum of funding avenues to choose from. The critical dimensions of this decision are discussed below:

•Interest rate basis: Mix of fixed rate and floating rate debt

•Maturity: The appropriate maturity composition of debt

•Currency composition of debt

•Which market segments should be tapped?

Note that these dimensions interact to determine the overall character of the firm’s debt portfolio. For instance, long-term financing can be in the form of a fixed rate bond or an FRN or short-term debt like commercial paper repeatedly rolled over. Each option has different risk characteristics. Further, the possibility of incorporating various option features in the debt instrument or using swaps and other derivatives can enable the firm to separate cost and risk considerations. Individual financing decisions should thus be guided by their impact on the characteristics of the overall debt portfolio such as risk and cost as well as possible effects on future funding opportunities.

Next let us address this question: “What should be the overall guiding principles in choosing a debt portfolio?” Giddy (1994) provides the following answer:

“The nature of financing should normally be driven by the nature of the business, in such a way as to make debt-service payments match the character and timing of operating earnings. Market imperfections that provide cheaper financing exist in practice in a wide range of circumstances.”

Let us discuss this recommendation in a little more detail. What it seems to say is that there should be some correspondence between, on the one hand, the sensitivity of the firm’s operating cash flows to environmental risk factors such as exchange rates and interest rates and the sensitivity of debt-service payments to the same factors. In addition, the time profile of debt-service payment should be similar to that of operating cash flows. Deviations from this are justified either when the firm possesses superior information so that it can “beat the market” or some market imperfection allows it to enhance cheaper funding.

Let us see how this principle should be applied to the different dimensions of the borrowing decision. Consider the choice between fixed and floating rate financing. Firms such as utilities, manufacturing firms and so on have relatively stable earnings or at least their operating cash flows are not highly sensitive to interest rate fluctuations. Such firms should naturally prefer fixed rate funding. If a firm has stable revenues in US dollars, it can reduce the probability of financial distress by borrowing in fixed rate dollars. Companies undertaking long gestation capital projects should ensure that sufficient financing on fixed terms are available for long periods and hence should prefer to stretch out their debt servicing obligations by borrowing for long terms. A factoring company on the other hand should finance itself with short-term borrowings.

Governments in some countries impose restrictions, which prevent a firm from tapping a particular market segment even though that may be the optimal borrowing route under the circumstances. For instance, during the first half of the 1990s, Indian government decided to discourage recourse to external debt finance and in particular did not permit short-term borrowing in foreign currency. On the other side, a particular market segment may be closed to a firm either because of its inadequate credit rating, investor unfamiliarity or inability of the firm to meet all the requirements – accounting standards, disclosure and so on – specified by the regulatory agency supervising the market.

In viewing the risks associated with funding activity, a portfolio approach needs to be adopted. Diversification across currencies and instruments enables the firm to reduce the overall risk for a given funding cost target. It also helps to increase investors’ familiarity with the firm, which makes future approaches easier.

Finally, it should be kept in mind that currency and interest rate exposures arising out of funding decisions should not be viewed in isolation. The firm should take a total view of all exposures, those arising out of its operating business and those because of financing decisions.


•The all-in cost of a particular funding instrument – The term “all-in” means that among the costs should be included not just the interest but all other fees and expenses.

•Interest rate and currency exposure arising from using a particular financing vehicle – Floating rate borrowing or short-term borrowing repeatedly rolled over exposes the firm to interest rate fluctuations. In the latter case, even the spread the firm will have to pay over the market index becomes uncertain. On the other hand, a long-term fixed rate borrowing without a call option locks the firm into a given funding cost so that the firm is unable to take advantage of falling rates. Funding in a foreign currency exposes the firm to all forms of currency exposure – transactions, translation and operating.

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