Capital Structure & Value

Financial theory tells us that there is an optimal capital structure derived from tax savings and the risks of financial leverage, but it says little about how to achieve the optimal structure for a specific organization.

The diagram below shows the hierarchy of value creation using cash, which represents the foundation for properly forming a financing structure with correct management. To make the right decisions, an organization should consider the following points:

• Decisions regarding capital structure, dividend payments, or share buybacks should stem from the overall policy of using/distributing cash. Generally, an organization should first strive to invest in positive NPV projects, and if that is not possible, then return money to shareholders.

• When organizing the capital structure, large organizations should maintain a credit rating within the A+ to BBB range to preserve sufficient sovereignty for making decisions during tough periods. Higher ratings typically offer less benefit in terms of independence and incur more tax losses, while lower ratings hinder organizations from making effective decisions.

• When paying dividends or buying back shares, attention should be paid to their impact on stock prices in the short term. Although such decisions do not affect the organization’s value in the long term, in the short term, they positively influence management’s reputation and increase expectations for value creation in the long term. If these expectations are not met, the price will drop again.

• The level of dividends should be determined based on bad periods, for instance, the low point of the profitability cycle. Dividends are regular in nature, and their reduction is usually perceived very negatively by the market (though there are exceptions).

• Share buybacks should be carried out to distribute irregular “excess” profits after dividends, because although EPS increases with this decision, it does not create value (cash decreases or debt increases). Unlike dividends, share buybacks do not create regular expectations, allowing the organization to more boldly finance new opportunities.

source:

Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels