Building a capital structure that adds value to your company’s operating performance is challenging because of the large number of judgments that must be made based on intangible evidence. On the one hand, noted economists have proved conceptually that in a perfect capital market, in which the effect of taxes is uniform, the capital structure does not contribute to value. As debt is added, levering up the return to the equity, the additional risk pushes down the equity valuation. This leaves the firm’s total value unchanged. However, when different capital sources are taxed differently, the formulation specifies a capital structure with as much of the tax-advantaged, low-cost capital as possible.
The capital markets are seldom perfect, at least in the short term, and a variety of frictions (such as taxes and bankruptcy regulations) spread costs unevenly among the capital sources. Therefore, theories generally agree an appropriate capital structure can add value and an inappropriate one can destroy it. In analyzing an appropriate capital structure, the following six factors known as FRICTO can be considered:
- Timing, and
Thanks to the “other” category, the FRICTO factors are mutually exclusive and collectively exhaustive.
Note: This discussion takes the perspective of the equity investor, such as you and whoever else has invested in your company. Without an equity foundation, no enterprise will get started. This brief discussion provides a conceptual overview.
The income factor is usually an investor’s first consideration. If a company can borrow at an interest rate lower than its before-tax return on assets, the difference between the earnings on the assets financed with debt and the cost of the debt goes to the equity owners. The ROE goes up. This positive effect is magnified when interest has a more favorable tax treatment than earnings for the equity holders.
Other factors must also be considered. As an early Baron Rothschild reportedly asked when a person with a recent inheritance sought investment advice, “Do you want to eat well or sleep well’ ?” A high degree of leverage is an eat-well strategy.
RISK VERSUS FLEXIBILITY: Sleeping well, or even reasonably soundly, requires consideration of the closely related Risk and Flexibility factors. Risk events for some companies may be flexibility problems for others. In this discussion, risk problems are those recurring events whose nature can be predicted but whose occurrence is uncertain. Business cycles are the most common type of risk event. They occur at erratic intervals, but their nature is sufficiently well known so their effects can be anticipated and dealt with. Businesses know inventories must be cut, receivables disciplined, and financial resources maintained to tide them over the trough in the cycle.
The analysis of risk events concentrates on the event’s effect on the existing capital structure. A risk event, almost by definition, should not require significant new financing. Risk events are often dealt with by hunkering down, converting assets to cash, and using the cash to service the existing financial obligations rather than rolling them forward. The analysis of a company’s exposure to risk events leads to such questions as: How well can the company meet its existing debt? Does it have sufficient resources to handle the situation? How many risk problems can it sustain at once without financial collapse?
Although the debt in the capital structure enhances the ROE, the value of this extra return may be discounted. At the extreme, if the company’s risk exposure is excessive, the loss in value from the exposure to financial risk may be greater than the value created from the extra earnings.’ If this happens, the equity value would actually be increased by a more conservative capital structure.
Flexibility events require the company to access the capital markets for additional financing. Such events do not allow the company merely to transform its assets into cash to service its external obligations. They require that the company spend more cash to protect its position, to grow, and to survive.”Positive” flexibility events can be created by a highly profitable company that is exceeding its sustainable growth rate. This company usually has little trouble obtaining the necessary financing.
The “negative” flexibility events are the “unknown-unknowns” of the financial world. They are large and life-threatening to the company. Innovation threatens a major product: the pocket calculator made the slide rule, the rotary calculator, and the interest-rate table-book all obsolete. Sometimes a risk event, such as a labor situation, becomes so serious that it turns into a flexibility crisis.
A different way of saying this is that the earning per share will increase as debt is substituted for equity. At some point, the price-earnings ratio begins to fall because of the greater problems the level of debt creates for dealing with a risk event. When the price-earnings ratio falls faster than higher leverage increases the earning per share, the market price will start to fall.
The analytical perspective for flexibility events requires consideration of the types of flexibility problems that might occur for a company and the amount of funds needed to resolve them. Has the company access to these funds? Can the company raise funds at a reasonable price, a cost the new assets can earn with room to spare? Or, will the company have to give away some of the existing equity owners’ value to survive? If so, how much?
All-equity financing clearly leaves a firm with the greatest room to deal with flexibility problems. This is too great a sleep-well strategy for most entrepreneurs, who want to enjoy a high return on their equity. On the other hand, too high a level of senior claims can create skepticism about the company’s survival. The capitalization rate for debt is raised. The adverse effect on the value of the equity is the same as that described in the risk situation: ROE may be higher, but it is more than offset by a lower valuation multiple.
Unfortunately, it is not easy to identify the precise debt-capital ratio at which the market takes fright nor the point at which the fright turns to panic. Moreover, these points probably change with market conditions. When the market is optimistic and confident about the future and the company appears strong in its position, a greater proportion of debt is not only tolerated but encouraged.
WARNING: The danger for companies pushing too close to the limit is that market fads can change suddenly. Investors become more conservative. Liquidity, not growth or earnings, becomes the touchstone of value. Acceptable capital structures become more conservative and, often in this environment. the value of equity is discounted. The firm at the edge finds the cliff has collapsed beneath its feet. Raising equity funds to restore the foundation is now much more expensive than anticipated.
Considering the difficulty of determining where the edge of the precipice is, the optimal capital structure, balancing eating and sleeping to create the highest value for the equity holder, fortunately lies more on a mesa than a mountain peak. There is reasonable room for capital-structure decisions that enhance stockholder values.
Control factor matters for the smaller enterprise, for example, often point to debt as the favored financial source because additional equity will dilute the existing control position. Entrepreneurs, however, often overlook the control lenders exercise through the structure of the loan agreements. As the proportion of debt increases, these terms become stricter and circumscribe management’s decisions. If these terms become too onerous, issuing equity
may actually sacrifice less control than loan covenants would take.
Timing factors become important when the market situation tempts management to vary from the strategic plan laid out. For example, if the plan is to issue short-term debt but long-term interest rates fall to low levels,you may consider raising long-term debt immediately although the plan had been to delay long-term debt.
Timing factor is also important when you are planning a sequence of issues for a company that is in the “fourth” state of fund needs. The eat-well, sleep-well tradeoff is between issuing debt now (in the hope of raising the market price of the common stock for a subsequent issue of equity) and of issuing equity now (to provide a base for easier future debt financing). An assessment of what type of financing is in current favor in the marketplace, and an estimate of what will be in favor at the time of the next issue are important aspects of judgment in making the decision.
The “other” factors can tip the decision either way. For instance, estate planning may incline the entrepreneur to raise debt to replace equity, making it easier to sell the business to another entrepreneur. Occasionally, creating liquidity and a way for investors to exit may require the enterprise to make a limited issue of equity.
KEY POINT: Income factor usually point toward more debt; risk and flexibility considerations usually point toward less debt. The remaining factors can point either way depending on the circumstances.
Applying the FRICTO factor:
Although in this discussion the FRICTO factors have been applied to the capital-structure decision, these factors are also appropriate for assessing capital-investment and dividend decisions. Thus, FRICTO offers a framework in which the effects of most financial decisions can be analyzed.
With respect to capital investments, the major analytical issues are the return (income) the project offers and the rate of return (cost of capital) that should be demanded given the uncertainties (risk and, sometimes, flexibility) associated with it. Timing is often a factor – should the project be undertaken at once or deferred’?
Similarly, the dividend policy issue can be evaluated with the FRICTO factors.
- Does paying a higher dividend mean cutting back on investments (reducing income growth)’?
- Does it mean more debt (increasing risk and flexibility exposure)?
- Does it mean issuing more equity (cutting future income and diluting control)?
- Will it create greater value (the sum of the dividend and the stock price)?