Valuation: Measuring and Managing the Value of Companies, Fifth Edition

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Capital Structure

Careful design and management of a company’s capital structure do more to prevent value destruction than to boost value creation. When managers make decisions about capital structure, they usually have much more to lose than to gain in terms of value—as underlined by the sharp increases in bankruptcies following the burst of the high-tech bubble in 2001 and the credit crisis in 2007.

In this chapter, we discuss tools and frameworks that can help managers make three levels of decisions about capital structure. The first level is strategic: How much funding does the company need to support its core strategic plans? And how much flexibility does it need, on the one hand, to make additional investments as opportunities arise and, on the other, to provide robustness to withstand any downturn in the business cycle and other adverse economic conditions? The second level concerns the company’s target capital structure: What mix of debt and equity best fits the company’s needs for core funding, flexibility, and robustness? At the third level, decisions are about the tactical, short-term steps required to adjust the capital structure in line with meeting these long-term targets. For instance, should the company hold on to excess cash or pay it out by increasing dividends or repurchasing shares?

This chapter addresses the following topics in detail:

• The impact of capital structure on value creation for shareholders

• The role of credit ratings in capital ...