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Executive Institute: What is Optimal Capital Structure?

  • By Andrew Deichler
  • Published: 8/8/2016

Corporate treasury and finance executives attending the Executive Institute at the 2016 AFP Annual Conference in Orlando are surely concerned about capital structure. It’s a good thing then that Michael Roberts, the William H. Lawrence Professor of Finance at the Wharton School of Business, and Richard Rivero, managing director of investment banking for Goldman Sachs, will provide attendees with insights into how they can obtain an optimal capital structure.

“Capital structure is in the top three on the list of what corporate treasury and finance has to pay attention to,” said Craig Martin, executive director of AFP’s Corporate Treasurers Council. “So now, with the Brexit vote, people are afraid of what they don’t know that could be around the corner. Well, that’s exactly the point—you don’t know. But what you can be is prepared and ensure that you have liquidity and adequate sources of funding—and make sure that you have a good, strong balance sheet and capital structure. And then you’ll be able to survive that unknown.”

Roberts, whose research focuses heavily on capital structure and its effects on corporate investment and equity returns, agreed. “The trick is trading that off against funding potential growth; it’s a fine line,” he told AFP in an interview.

In the current environment, companies are holding onto more cash than usual. This was evidenced most recently by the latest AFP Corporate Cash Indicators® (AFP CCI), which found that U.S. businesses accumulated short-term cash at a far quicker pace than they did in the previous quarter and a year earlier. And that’s not expected to change; the AFP CCI also found that companies are expected to significantly increase cash holdings in the current quarter as well. “We’re just going to have to have more liquidity than we normally do,” Martin said.

Rivero, who advises Goldman’s corporate clients regularly in a quantitative role, agreed that treasury and finance executives need to focus their attention on capital structure. “Capital structure is strategic,” he said. “A lot of what drives corporate performance in the equity markets over the long term, is companies coming up with new technologies, figuring out ways to grow and doing things to satisfy consumers. But the other piece of that is how you finance yourself. I’m not sure if it’s 50/50, but it’s not 99/1. Capital structure does matter.

Rivero added that, over the past few years with the M&A boom, Goldman has been working to ensure that its corporate clients’ balance sheets are positioned to acquire growth and are resilient to the next black swan event. “Liquidity has become important,” he said. “Clients are increasingly asking about tweaks to the capital allocation profile. I get it from CFOs and treasurers all the time. Is there an optimal capital allocation policy? There probably is, so what’s the bang for the buck you get from having it? That’s an interesting question for corporate America.”

According to Roberts, capital structure, like most all finance, is firmly grounded in academic theory. He sees the work that Rivero does as a “perfect complement” to academics’ work, in that Rivero tests and informs theory using a different way, relying on “field experiments” by helping to implement capital structure policy at various clients. In contrast, academics test existing theories and inform new ones using large sample data. “In this way, academics can provide guidance to practitioners on what matters on average or for subpopulations of the corporate sector,” Roberts noted.

Of course, another key difference is that firms like Goldman have to deal with the practical realities of implementing optimal capital structure policies at individual firms, Roberts added. “In academia, we can abstract from certain relevant issues to identify or isolate the importance of specific capital structure determinants—to know what matters and when—for most firms or a typical firm,” he said

Goldman and its corporate clients don’t have that luxury. “For example, if a CEO is debt-averse—something I’ve dealt with when working with leaders not far removed from the great depression —it doesn’t matter that the model tells you an increase in debt will boost shareholder value through interest tax shields and maintaining lending relationships to fund future growth,” Roberts said. “If the CEO doesn’t like debt… that’s it.”

But perhaps the concept of “trusting your gut” like a CEO is clearly doing by being debt-averse is giving way to more analytics-based decisions. In making predictions, Rivero said that he has been spending more and more time with data and models. “Gut matters, but boards and executives seem to be leaning towards data,” he said. “Of course, you can’t have a black box model and some of the math gets really hard really quickly, but this is becoming industrialized.”

Martin pondered whether optimal capital structure truly exists. “It does, but it’s individual companies’ optimal capital structure,” he said. Whether there is a universal method that can be applied across the board is unclear. But perhaps at this year’s Executive Institute, attendees will begin to glean some answers.

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