Capital Structure

Capital Structure

This blog will introduce capital structure of companies. The company pursue maximizing shareholder’s’ wealth and company value. By decreasing the weighted average cost of capital (WACC), companies can improve shareholder’s wealth and company value. Debt is a lower cost than equity. Meanwhile, debt can reduce taxable profit. Thus by increasing proportion of debt in the whole capital, WACC will decrease. In other words, improving gearing ratio will create more company value. However, with increase of gearing ratio, the company will have high risk of financial distress. Meanwhile shareholder will require high return. In addition, the company also face business risk. Hence, managers should choose a suitable proportion of equity and debt, in order to build optimal capital. On the other hand, according the theory of Modigliani and Millar, it claims the total value of any company is independent of its capital structure. Thus there is no optimal structure. However, this theory is established under many assumptions such as there is no taxation, there are no costs of financial distress and liquidation, individuals can borrow as cheaply as corporations. Because the assumptions are rigid, I think it is difficult to implement.

Li Ning is a famous company in China which run sport clothes. Its CEO, Li Ning was an outstanding gymnast. On January 2013, this company issue 241 million dollars of bond. The company increase its gearing ratio again. Last year, it has raised 120 million dollars by bond. In fact, since 2008 the company has adjusted its capital structure in order to occupy market share. In 2008, china holds Olympic Games. Li Ning represents Chinese people lighted final Olympic flame. Li Ning catches this marketing opportunity and expands a number of its shops in China. To achieve this, in 2008 the company’s gearing ratio increased to 52%. (Li Ning Annual Report, 2009) Compared its competitor, Anta’s gearing is 10% in 2008. (Anta Annual Report, 2009)Within five years, Li Ning company has been utilizing this capital structure which is high gearing. However, these years the economic is slump and purchasing power keep low. Thus Li Ning makes a large number of inventory with its sharp expand. This leads its cash flow became intense. To remit this, Li Ning has to issue bonds again in 2013. (Financial Times, 2013)

In this case, in order to extend sharply, manager adopts capital structure with high gearing. This capital structure is low raising cost and reduces taxable profit. And it is effective to expand. Li Ning’ shops have exceeded Adidas in China. However, the manager may pay less to its shortcomings or the manager may prefer to high risk, and this leads to the company value decrease. Because economic slumps and expand is sharp, there are large stores and intensive cash flow. These make business risk and financial risk. Meanwhile, clothes retailer is sensitive for general level of economic activities. Thus the capital structure increases risk of financial distress. Furthermore, such high risk makes shareholders require high return, but it cannot be satisfied. As a result, from 2011 to 2013, its share price decreases from about 17 HK Dollar to almost 4.8 HK dollar. (Business Week, 2013) this decreases company value.

Therefore managers should balance proportion of equity and debts in capital structure, according to their industries and aims. Also how to find the good point which balances risk, develop and cost is a challenge for managers.