| 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.
MAJOR
DIMENSIONS OF THE FINANCING DECISION
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.
OTHER
PARAMETERS
•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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