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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.