Capital structure and financial flexibility

For Chief Financial Officers (CFOs), determining their firm’s optimal capital structure – the most efficient combination of debt to equity held – is akin to the Holy Grail.

A firm which is too heavily indebted may find it difficult to borrow from lenders; whereas one which has too little borrowing risks being underleveraged (i.e. having a low ratio of debt capital to equity capital), posing problems of its own.

Survey studies have shown that a CFO’s top priority when determining the capital structure is maintaining financial flexibility – the firm’s ability to borrow funds to take advantage of new investment opportunities or sustain ongoing projects when they need to. If for instance, the firm has already borrowed heavily today (meaning low debt capacity), it is not financially flexible in the sense that in the future it will not be able to increase its borrowing to fund new profitable projects or cope with any temporary setbacks in ongoing investments.

Precisely how CFOs do this has been less clear.

Research by Leeds University Business School and Queen Mary University London casts light on how CFOs determine the optimal capital structure for their firm and make changes in an attempt to render their firms capable of addressing future investment shocks.

CFOs decrease the firm’s leverage ratio (i.e. debt over the sum of debt and equity) when they expect either a small or a large shock in the firm’s investment opportunity set. This is because CFOs act proactively in anticipation of future shocks and reduce the firm’s leverage, so that the firm preserves a greater debt capacity today to be able to borrow in the future and take advantage of potential profitable new investment opportunities (good shocks) or keep already undertaken investments running in the event a loss (bad shock).

To proxy expected investment shocks facing these firms, the researchers tracked the prices of equity options for a sample of 817 US companies from 1996 to 2017. The researchers used the market prices of equity options to extract the expectations of CFOs for small and extreme movements in the firm’s stock prices, which are used as proxies of the expectations of CFOs for small and large future investment shocks.

The research showed that CFOs reduced borrowing when they expected small or large future investment shocks - as captured by expectations for small or big movements in the firm’s stock price.

The study also found that the effect of expectations of investment shocks on leverage differs across firms. The leverage of the small and financially constrained firms is more sensitive to expectations for shocks. This is because these firms have a greater difficulty in borrowing. Therefore, in the anticipation of future shocks, their managers borrow less today to preserve a greater debt capacity and set a lower leverage as a result. The study also shows that in setting the current quarter’s leverage, CFOs take into account expected shocks which may occur beyond the current quarter. This implies that CFOs care for both short-term and long-term shocks.

Dr Costas Lambrinoudakis, said:

We know that a company’s earnings and its valuation can be adversely affected if its capital structure isn’t optimal. But despite this being one of the CFOs most important jobs, the mechanics of how they do it is little understood. CFOs use their judgement, drawing on indicators such as the profitability and size of the firm, its book-to-market ratio and opportunities and risks they see in the marketplace. But our research confirms that financial flexibility is uppermost in CFO’s minds, and amongst the most important factors affecting how they set the capital structure.