Is there an optimal capital structure?

As mentioned in my previous blog, the recent fall in crude oil has impacted many large oil companies. On 4^th March, oil and gas producer Afren announced it was defaulting on a $15m interest payment (Kavanagh & Wallis 2015, Aglionby & Thomas 2015, & Casiraghi, 2015). This default casts doubt on their capital structure, leading me to assess the options available to firms when deciding upon their capital structure.

Companies must decide on the level of debt and equity used to finance their business. Debt finance is much cheaper than equity; however, it has to be repaid whereas equity does not. The traditional view suggests that because debt is cheaper due to tax advantages, increasing gearing would reduce the weighted average cost of capital (WACC). Hence, shareholder wealth is increased as cash flows are discounted at a lower level.  Despite this, the traditional view suggests as gearing rises, the associated risks to shareholders increase due to the large interest payments faced. Whilst debt repayments remain constant, demand may not. This is certainly applicable in the case of Afren who, having generated $1.2bn of debt, were faced with a 60% drop in the price of crude oil. As debt repayments must be maintained, the company was faced with serious cash flow difficulties leading to their default on interest payments. To avoid instances like this, the traditional view proposes there is an optimal capital structure; if gearing is too low shareholder value opportunities may be missed, alternatively if it is too high risks are heightened, seen in the case of Afren.

Contrastingly, Modigliani & Miller (1958) found that WACC remains constant regardless of gearing levels, implying shareholder wealth cannot be maximised through capital structure. However, this paper was highly criticised for its major assumptions that there is no tax, financial distress or bankruptcy costs. In response to this, Modigliani & Miller reviewed their paper in 1963 to include the effect of taxation. Through this modification they found the optimal capital structure is as much gearing as possible due to the tax advantage of debt finances which decreases the WACC, thus maximising shareholder wealth. It could be argued Afren took this approach as they have extremely high levels of debt. Whilst this initially maximised shareholder wealth, with share prices reaching an all-time high in October 2013 of 166p, it is now having the opposite effect. Share prices hit a yearlong low in January, and reduced almost 27% to 6.6p the day the interest default was announced. Standards & Poor rating agency also reduced the company to a double C status, defining them as highly vulnerable; a further concern for shareholders.

Afren’s difficulties can potentially be explained through the work of Miller (1977) who again revisited the initial paper, this time including bankruptcy costs. As gearing levels increase, so do interest payments and the risk of being declared bankrupt. Miller found tax advantages from increased debt were counterbalanced by the increased risk. This increases the rate of return demanded by shareholders, thus Miller concluded WACC remains relatively unaffected by capital structure; parallel to the initial study. However, this could also bring us back to the beginning of the blog, in which it was suggested there is an optimal capital structure involving appropriate gearing and equity levels. If gearing is increased to an optimal level, tax advantages can be gained and risk can be maintained at a moderate level. It would seem Afren increased gearing too much, not foreseeing the drop in crude oil prices. Afren are in a dangerous position, having defaulted on a $15m interest payment and with nearly $400m of debt due to mature next year. In a bid to help the situation the company are seeking a capital restructuring, potentially increasing equity holdings. Afren need to raise in excess of $200m to achieve this, a figure higher than its market value. If this is achieved, Afren have warned this new equity will ‘substantially dilute the interests of the company’s current shareholders’.

In my opinion, by maximising gearing Afren have ultimately ended up damaging shareholder wealth despite having maximised it for a short period of time, suggesting this capital structure is not sustainable in the long term. Uncertainty in the economy, still prevailing since the financial crisis, further enhances the risk of high gearing levels. Therefore, I believe there is an optimal capital structure that involves the balance of making the most of low cost debt and its associated tax relief, whilst avoiding financial distress and bankruptcy costs. Having said this, I don’t believe there is a ‘right’ answer; each company will face its own risks and should therefore determine what the best capital structure for their particular needs is.

References

Aglionby, J. & Thomas, N. (2015), Afren defaults on $15m interest payment. Retrieved on 4^th March 2015, from http://www.ft.com/cms/s/0/e7d380c2-c23f-11e4-bd9f-00144feab7de.html#axzz3Ti5FZYjU

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Casiraghi, L. (2015). Afren defaults on bond as it holds out for restructure deal. Retrieved 4^th March 2015, from http://www.bloomberg.com/news/articles/2015-03-04/afren-defaults-on-bond-as-it-holds-out-for-restructuring-deal

Kavanagh, M. (2015). Afren shares plunge more than 65% on funding crisis. Retrieved 2^nd March 2015, from http://www.ft.com/cms/s/0/781cc12e-a612-11e4-abe9-00144feab7de.html#axzz3Ti5FZYjU

Kavanagh, M. & Wallis, W. (2015). Seplat granted extension for Afren offer. Retrieved 1^st March 2015, from http://www.ft.com/cms/s/0/9b7d2688-a89f-11e4-97b7-00144feab7de.html#axzz3Ti5FZYjU

Modigliani, F. & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment, The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org/

Modigliani, F. & Miller, M. (1963). Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, 53(3), 433-443. Retrieved from JSTOR http://www.jstor.org/

Miller, M. (1977). Debt and Taxes, The Journal of Finance, 32(2), 261-275. doi: 10.1111/j.1540-6261.1977.tb03267.x

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.