Capital Structuring

Alastair Graham

• Publisher: Routledge
• Year: 2004
• eBook ISBN: 9781135456276
• Topic: Business
• Subtopic: Business General
• Index: Business

The Glenlake Series in Risk Management strives for simplicity, clarity, and ease of application on the complex subject of risk management. As every business academic and professional knows, risk management--whether for new products/services, transaction, interest rate, currency, cashflow, credit, or market risk--is now regarded as the most important business tool. This series involves time-tested training tools--whether for classroom application or individual study. Each title in the series makes extensive use of case studies, adapted specifically for a sophisticated international audience.

The topics covered in this title covers include: quantifying the need for funds from outside the business; an overview of the various funding options available to managers; equity funding; debt funding; hybrid financial instruments; models on the optimal capital structure; debt profile management; refinancing; glossary of terms.

1
Introduction to Capital Structuring

In one way or another, business activity must be financed. Without finance to support their fixed assets and working capital requirements, businesses could not exist. There are three primary sources of finance for companies:

• a cash surplus from operating activities
• new equity funding
• borrowing from bank and non-bank sources. Non-bank sources are mainly investors in the capital markets who subscribe for bonds and other securities issued by companies.

New equity funding always should be available, at a price, to companies that can provide a good economic argument for wanting to raise money.

For many companies, however, all-equity finance is an unsatisfactory capital structure. Debt, because it is not permanent and can be much cheaper to service, is often an important ingredient in the funding mix. Debt capital, however, is not always available. Lenders could refuse funds to companies when the perceived credit risk is too high.

By taking into account a company’s particular circumstances, management should decide what is the most appropriate mix of internal and external funding, and of equity and debt, i.e. how the company should structure the necessary capital to finance its activities.

Objectives

A variety of factors or objectives in the management of capital structuring will be explored more fully in later chapters, but briefly they are:

• deciding the optimal capital structure for a company, over a short-term and long-term planning period
• ensuring that funds are always available to finance the company’s growth and development
• minimizing the cost of capital
• deciding how much to borrow, who or where from, when, for how long, and in what currency
• ensuring that money will be available to meet loan repayment obligations, and that refinancing would be available if required
• monitoring exposures to interest rate risk and, where appropriate, taking measures to hedge the risk.

A further objective might be to provide the company with the financial resources to continue trading in the event of a recession or downturn in one or more of its business markets.

Companies often will expect their financial advisers and bankers to assist in these matters.

Benefits of Debt Capital

Debt capital is provided mainly by two types of lender or investor. These are banks (bank loans and facilities) and institutional investors (for example, pension funds, mutual funds and life assurance companies), who invest in debt securities, such as bonds and commercial paper.

Debt capital has two important benefits for a profitable company needing external finance to grow and develop:

• cost
• flexibility.

Debt capital is often a fairly low-cost source of finance. Interest on debt is sometimes an allowable charge for tax purposes, and in such cases the cost of debt capital for a profitable company is therefore its after-tax cost. For example, when the rate of taxation on corporate profits is 30%, the effective after-tax cost of a 10% loan is just 7% (10%×70%).

Many companies are able to raise debt capital at an attractive rate of interest, although the cost of any particular debt varies with circumstances, e.g. the debt instrument, the borrower’s creditworthiness, the term of the loan, etc.

Debt is rarely perpetual, and must be redeemed at some future time. This can be an advantage to companies that need external funds for a limited number of years. Debt capital can be borrowed and repaid to suit the expected cash flows of a company, giving the company greater flexibility to plan and control its capital structure.

Example

Beta, a public company, is planning a $100 million investment that is expected to earn annual profits of $50 million for three years. The company has a good credit rating, and could borrow for three years at 6% per annum or for five years at 6.20% per annum. Current interest rates are considered low; they are unlikely to fall much further and could rise within the next two to three years.

A decision has been made to undertake the investment, but the method of funding, either an issue of new equity stock, or a bond issue, has yet to be decided.

Analysis

A drawback to equity funding is the permanence and cost of the funds. Equity stocks, once issued, are not easily cancelled, and stockholders will expect a satisfactory return.

One advantage of debt capital, particularly when interest rates are low, is that any surplus profits above the cost of financing the loan can be paid out to existing stockholders. A second advantage is that the company is not committed to a permanent increase in its long-term capital funds, because eventually the debt will be repaid. A further aspect of the flexibility of debt funding is the term of borrowing. The company needs the funds for an investment lasting just three years. However, the company has the option of borrowing for a longer term, say five years, in the belief that debt is currently very cheap, and it would be profitable in the long term to borrow for five years rather than for three years, even though the interest rate would be 20 basis points higher.

Debt and Creditworthiness

The major drawback to debt capital is the risk of being unable to meet the loan repayment obligations in full and on schedule. Companies with a high proportion of debt in their capital structure are likely to be considered a high credit risk by would-be lenders and investors. When a borrower’s credit rating (or perceived creditworthiness) is low, the cost of borrowing could be very high, and the benefits of debt capital therefore much lower.

Credit ratings affect the cost of new borrowing. Suppose, for example, that a large multinational company suffers a fall in the credit rating on a bond issue from A to A-. As a consequence, the cost of raising new debt capital will go up, say, by 20 basis points (0.20%). To borrow $100 million would then cost the company an extra $200,000 ($100 million× 0.20%) each year in higher interest costs.

The Origins of Debt Management

Debt management is concerned with planning and controlling the debt element of a company’s funding mix.

For a small company, borrowing effectively is limited to a loan (or facility) from one or more banks. A larger company, in contrast, has a wider range of debt markets available to it. Large companies can borrow from banks, or tap domestic, foreign or international markets for bonds, medium-term notes, commercial paper and hybrid instruments, e.g. convertible bonds.

Evolution of Markets

The origin of today’s debt markets can be traced back to the creation of the eurodollar in the 1940s when under the Marshall Plan for economic recovery in Europe dollars could not be repatriated to the US. Eurodollars are simply dollars deposited with a bank outside the US. From the 1950s, a pool of offshore dollars accumulated with banks outside the US.

Over a period of time, this created a substantial pool of dollar-denominated funds held offshore by non-US citizens. This made very little impact on the international markets until the early 1960s. At this stage, in order to protect its domestic borrowers, the US authorities put in place a new tax. This was the interest equalization tax.

Because the rate of interest in the US was substantially lower than in most European countries, it became more advantageous for foreign borrowers to issue bonds in the domestic US market than in their home markets. This was still the Bretton Woods era of fixed exchange rates. In order to restrict the availability of dollar liquidity to domestic borrowers, the new tax charged overseas borrowers with the difference between the cost of borrowing in US dollars and the cost of borrowing in the borrowers’ domestic currency. This effectively put a stop to foreign borrowers’ access to US dollar funding. However, a few far-sighted investment bankers recognized that there was a huge supply of US dollars held offshore. They reasoned that if these dollars were lent to overseas borrowers, using securities issued outside the US, then the tax could not be applied. This was the start of the Eurobond market, a market that now issues $400 billion-worth of securities annually.

The eurodollar originated to accommodate governments in the old eastern bloc and the middle east, organizations and individuals (expatriate workers, etc.) who wanted to:

• hold dollars, then the reserve currency of the world, because the dollar was perceived as the currency offering the best protection against value depreciation, but at the same time,
• wanted to avoid exchange controls, the political risk of having dollar deposits seized and the regulation of dollar deposits by the US government that would have applied to dollars deposited in the US.

The pool of dollars held with banks outside the US was aggressively managed, and eurodollar investments were moved regularly to obtain higher yields in the relatively unregulated environment. The volume of eurodollar lending and borrowing grew as a result of:

• the premium yields paid on eurodollar deposits compared with domestic dollar deposits in the US
• the evolution of multinational banks and corporates
• the high dollar earnings of the oil-producing countries in the aftermath of the 1970s oil crisis, and the reluctance of these producers to place the dollars with banks in the US
• the demand from borrowers for dollar-denominated loans as a low-cost and stable source of funds, compared to the cost of borrowing in local currencies.

Over time, other eurocurrencies emerged. It became possible to hold other major currencies offshore, i.e. with banks outside the country of origin of the currency (deutschemarks, French francs, sterling, yen, etc.). For example, Swiss francs held offshore are likely to be deposited with an overseas (non-Swiss) branch of a bank that also has a branch or branches inside Switzerland. The customer’s account might be with the London branch of Credit Suisse, thus allowing the customer to operate the Swiss franc account without being subject to the constraints of the Swiss banking system. At the same time the customer would benefit from the perceived stability of the Swiss franc and the interest yield available to holders of Swiss francs. The growth in eurocurrency markets can be measured by the fact that in aggregate, eurocurrency funds are now in excess of $2,000 billion.

Eurobonds

The requirement for higher yields by owners of eurocurrency deposits led to the development of the eurobond market in the early 1960s. The market developed to bring together institutions wishing to borrow in dollars with investors wishing to hold offshore dollar assets, i.e. bonds. It was successful largely because it was unregulated and easily accessible.

Eurobonds are debt securities that are distributed internationally and subsequently traded by dealers in several international financial centers. They are therefore purchased largely by investors with eurocurrency deposits, who are looking for a good return on their investments.

The initial market was for eurodollar bond issues only. Eventually other segments of the eurobond market developed, dedicated to eurodeutschemark, euro-yen, euro-sterling, etc. The market grew rapidly, feeding off its own success. Eurobonds became easily tradable, with widespread marketing outlets among banks.

• Investors were able to receive interest paid gross without any deduction of withholding tax.
• As the eurobond market grew in size, a market infrastructure also developed, with a more efficient secondary market and specialized settlement systems (Euroclear and Cedel).

Several domestic capital markets also have grown in recent years, encouraged by the removal of restrictions and regulations. These markets, such as the US private placement market and the yen public and private markets, have become much more accessible to foreign as well as to domestic borrowers.

A capital market cannot develop unless the increase in borrowing demand is matched by an increased supply of investor funds. Investor demand for eurobonds and other bonds grew for a number of reasons.

• Liquidity. Bonds can be sold into the secondary bond market and the proceeds applied to unforeseen funding requirements as they occur. The major bond markets in Europe and the US are highly liquid with continuous two-way prices available at narrow bid-offer spreads, allowing bonds to be bought or sold quickly with a single telephone call.

The ability to buy and sell bonds readily enables investors to switch the funds into investments denominated in different currencies as they shift their view about future changes in exchange rates.

• Yield. Borrowers are often prepared to pay premium yields to investors in return for a specific facility, such as a eurobond issue with relaxed covenants.
• Foreign exchange exposure hedging. Foreign exchange risk can be hedged by issuing bonds in a currency in which a company also has commercial receipts. By matching debt payments with an income stream in the same currency, it is possible to remove the risk of rising borrowing costs due to adverse exchange-rate movements. This would occur if the currency of borrowing strengthened against the borrower’s domestic currency.
• Tax benefits. In some cases there can be substantial tax benefits in holding securities offshore.

Funding and the Capital Markets

Decisions about raising capital are influenced by investors’ attitudes that borrowers cannot ignore. For example, a company cannot easily raise funds by issuing sterling commercial paper or by issuing bonds in the US private placement market, if there is insufficient interest in these markets for the planned issue. Similarly, a company cannot obtain a ten-year bank loan if banks ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• 1: Introduction to Capital Structuring
• 2: Quantifying the Need for External Funds
• 3: Funding Options
• 4: Equity
• 5: Debt
• 6: Hybrid Financial Instruments
• 7: Optimal Capital Structure
• 8: Debt Profile Management
• 9: Refinancing
• 10: Glossary