Value: The Four Cornerstones of Corporate Finance

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Capital Structure

Capital structure decisions, including those related to dividends and share repurchases, are important—not because getting them right creates a significant amount of value, but because getting them wrong can destroy tremendous value. In 2006, for instance, a number of very large companies received proposals from investment banks to increase their debt levels considerably and pay out substantial amounts to shareholders (some as much as $50 billion)—with the idea that this would increase earnings per share (EPS) and share value. Fortunately, none of the companies decided to lever up in this manner; if they had, several of them would have found it difficult to survive the financial crisis that began in 2008.

The primary objective of a company's capital structure should be to make sure it has enough capital to pursue its strategic objectives and to weather any potential cash flow shortfalls along the way. If a company doesn't have enough capital, it will either pass up opportunities, or worse, fall into financial distress or bankruptcy (or need a government bailout). Having too much capital can always be remedied by increasing future distributions to shareholders.

Capital structure can be boiled down to three issues: (1) What is the right mix of debt and equity in a company's capital structure? (2) When should a company go beyond simple debt and equity and use complex capital structures (i.e., financial engineering)? (3) What combination of dividends and/or share ...