Capital Structure, Cost of Capital and Financial Flexibility
by Steffen Diel, Head of Treasury Finance, SAP AG, and Simon Regenauer, Director Capital Markets, Merck KGaA
This article provides a discussion on capital structure, cost of capital and financial flexibility considerations focused on large software companies such as SAP as part of their strategic task to establish and maintain an effective financing framework. The discussed topics are relevant for treasurers mainly from two perspectives: they form an important part of the treasurer’s curriculum as part of recurring strategic funding discussions with senior management; and the discussion broadens the scope of capital structure considerations with regard to the growth and increased importance of intangible businesses (e.g., knowledge based industries) in the global economy during the last two decades versus the role of traditional, i.e., tangible, business models.
The importance of capital structure
How important are capital structure considerations when trying to determine its optimum for a given company? In doing so, we purely take the practitioner’s perspective and abstract from the academic literature around capital structure and enterprise value. We refer to generally accepted models where suitable for this purpose.
The determination and management of the capital structure is a key component of a company’s strategy. The capital structure strongly influences the weighted average cost of capital (WACC) which is the most relevant benchmark for the creation of shareholder value (SV).
The WACC constitutes the basis for determining the discount rate in a discounted cash flow model, the most widely used business valuation method. In addition, the capital structure and several key financial ratios derived from it form an important basis for the analysis of the creditworthiness of a company by third parties (e.g., rating agencies) and debt investors (e.g., banks or bondholders). The determination of a target capital structure by senior management could serve as a starting point for setting up an appropriate framework for financing decisions. This target capital structure and the accompanying financing decisions have to be well understood by investors if deemed to be successfully implemented.
The relatively recent history of enterprise software companies has been characterised by low financial leverage compared to other industries (e.g., discussion and examples can be found in an analyst report by Merrill Lynch). During the last few years, a trend towards more aggressive financial policies, i.e., a higher proportion of debt financing in corporate capital structures (higher financial leverage), has been fuelled by shareholders and analysts with the goal of increasing shareholder returns at the potential expense of debt investors.
In the years prior to the financial market crisis companies with low financial leverage were partly criticised for conducting their business based on an under-levered balance sheet. It has been argued that the WACC of those companies might be too high as a consequence of its high reliance on equity (instead of financial debt) and value could be unlocked by leveraging up, lowering WACC and potentially return cash to shareholders.
The financial market crisis since 2008 has considerably changed that view with investors putting much more focus on corporate cash balances and low financial leverage (‘cash is king’) given a volatile environment of uncertain funding opportunities and rising refinancing costs. This renaissance of a generally more conservative sentiment towards financial policy peaked, for instance, in a cash position that more than doubled between 2006 and 2011 in major US technology companies according to Moody’s.