Corporate Capital Structure:
Recent Research and Events
Kevin Davis
Commonwealth Bank Chair of Finance, University of Melbourne
Director, Melbourne Centre for Financial Studies
kevin.davis@melbournecentre.com.au
03 9666 1010
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Outline
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Lessons of the sub-prime crisis
Thinking about Capital Structure
Capital Structure Theory
Capital Structure Evidence
Some Current Issues and Techniques
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Lessons of the sub-prime crisis
• Capital structure matters
– Potential exposure to financial distress costs
• High leverage
• Rollover risk
• Undiversified financing
• Robustness of “untested” financing innovations
• Complex, opaque corporate structures
– Credit risk premiums variable and important
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Thinking about Capital Structure
• Leverage (Gearing) – debt/equity
– Market value or book value?
– Effect on share price volatility
• Interest coverage
• Credit ratings and market ratings (CDS spreads)
• Hybrids
• Maturity
• Governance and Market Discipline implications
– eg infrastructure funds, market value leverage
covenants
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Capital Structure Theory
• Ongoing debate – “trade-off” versus “pecking-order”
• Compromise – reality?
– Firms issue cheapest securities
• “windows of opportunity” – undervalued equity
– Firms don’t closely manage “market value” leverage
– Reluctance to issue equity
• Information effects and negative market response)
– Consequently
• Long lasting fluctuations around some “target’
• Capital structure is cumulation of past decisions
• Market value leverage inversely related to recent stock
price movement
• Management builds up financial slack when possible
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Some Facts
• Debt ratios vary more by country than by industry
– Generally in range 0.2-0.3 (of assets)
– Australia has low ratio
• Imputation – what is the gain to shareholders
from reducing company tax?
• Average debt maturity relatively low
– Around 6 months internationally
• Australian corporate debt market relatively small
– Both long term and short term (CP)
– “intermediated debt” and role of banks
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Firm characteristics and leverage
Firm Characteristic
Leverage
Larger
Higher
Growth
Lower
Tech sector
Lower
More tangible assets
Higher
More profitable
Less
Past performers
Less
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Capital Structure Management Developments
• Increased importance of share buybacks
– Off-market buybacks and franking credits
• Rights issues versus placements and retail
subscription offers
• Increased use of hybrids
– Evolution of converting preference share structure
• Use of dividend underwriting
– Maintenance of cash position with high, stable
dividend rates
• Future role of ratings and CDS spreads
• Impact of Sons of Gwalia judgement
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Concluding remarks
• Important to understand and consider
– Relative cost of equity and debt (and tax issues)
– Real cost of options inherent in hybrid, innovative
financing
– Information effects of announcements
– Organizational structure consequences and
market perceptions of opportunistic financing
involving subsidiaries and intra-firm linkages
– Potential governance implications
• Currently: high cost of capital; premium on liquidity;
importance of having both bank relationships and
funding flexibility
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