- So, what is the optimal capital structure?
Well, it depends on the specific business circumstances.
For example, let's do a little thought experiment.
If income tax rates are high,
should a company have more borrowing
in its capital structure or less?
Let's think this through.
If tax rates are high,
that means I get a bigger tax deduction for interest.
If I get a bigger tax deduction for interest,
then loans are cheap
and I want to borrow relatively more.
So, in a situation where income tax rates are high,
companies would tend to have more borrowing
in their capital structure.
What about the quality of the collateral
associated with loans?
If a company has very good collateral,
then it's more likely to borrow more.
What about the stability of the cash flows of the business?
If you have a company
that has very stable, predictable cash flows,
you're able to borrow more.
Stable cash flows give comfort
to the lender, so you can borrow more.
With volatile cash flows,
banks are probably going
to insist that you borrow relatively less.
Let's look at two examples,
two of your favorite companies and mine,
Walmart and Google.
They have very different capital structures.
If you loan $20 billion to Walmart,
what will they probably do with the money?
Well, they'll use it to buy land
and buildings and trucks
and other tangible things.
Now let's imagine a catastrophic scenario
in which something goes wrong
with Walmart's business model
and they can't pay us back.
Well, all is not lost
because the law is with us.
If Walmart can't pay us back the $20 billion
that we lent them,
then we can go claim the land
and buildings and trucks
to recover at least some of our $20 billion.
So, we are willing to loan Walmart
a little bit more money
because their assets provide good collateral for loans.
We see that in Walmart's capital structure.
Only 40% of Walmart's financing has been provided
by the owners.
That means 60% has been provided in the form of loans.
How about Google?
If you loan $20 billion to Google
and something goes very wrong,
such that Google can't pay you back,
what do you do?
Well, you're in a tough situation
because Google probably used a lot
of the money to pay their employees' salaries.
They used it to pay for research and development,
they bought some servers and server farms.
The business model of Google
does not provide good collateral
for lenders in case of a catastrophe.
As a result, Google has received most
of its long-term financing from owner investment, 77%
meaning that only 23% has been borrowed.
Note, Google's choice of low leverage
is of course much more complex than is portrayed
in this simple discussion.
Low leverage gives Google more financial flexibility.
If you want more details about why Google
has such low leverage,
contact the company's chief financial officer.
Now is there an optimal capital structure?
Yes, there is and that level of leverage
will differ depending on the circumstances of the company.