A capital structure is a financial statement that summarizes the debt and equity that a company has raised for its business operations. Most companies do not have enough capital to pay off all their debts, but are not allowed to go bankrupt because they may still face future obligations. So when companies can’t raise money on their own, they borrow it from other sources (e.g. financial institutions, or by issuing bonds or other securities) or pay it to their existing shareholders in the form of dividends.
Capital structure in corporate finance
Capital structure is a term used in corporate finance to describe the way in which a firm organizes its finances. Capital structure consultants agree that financial theory distinguishes between different financial structures for an organization based on the degree of debt and equity that the firm can raise, and subsequently, its ability to all debt obligations (debt servicing). The most common method is a firm with both debt and equity components in its capital structure; there are also other methods available within alternative financial structures.
The relative size of each component (debt and equity) affects a firm’s risk profile and its cost of capital. The debt-to-equity ratio is often used in macroeconomics as a simple measure for evaluating the overall risk that a company may pose to the financial system. The debt-to-assets ratio compare the total amount of assets with what it owes in assets.
Capital structure arbitrage is an approach to making money from mispricing in the capital structure of companies. It typically involves taking advantage of discrepancies between similar financial instruments which are priced differently due to differing tax treatments, accounting treatments, regulatory treatment or market conventions. Key success factors here include investment horizon (short versus long), understanding of corporate finance topics such as optionality and leverage, and risk preferences towards volatility and correlation.
Capital structure arbitrage tends to work best in high-yield debt markets, where the different treatments of various classes of securities make it possible to profit from mispricing in a low-risk low-return environment. The arbitrage is based on the theory that a large difference in value between two debt instruments with similar risk characteristics could be attributed to their difference in tax treatments.
The practice of capital structure arbitrage commonly extends across countries, and may occur simultaneously across multiple markets or industries. Examples include the differences between bond capital structures and equity capital structures between countries like Japan and Europe.
Capital structure arbitrage is a phenomenon that occurs in many countries where there are different tax treatments of debt and equity. An investor may buy a bond which pays tax at a lower rate than similar stocks, and then issue a call option against the stock to an investor who is willing to sell the stock at the strike price but who would not have bought it otherwise.
Capital structure arbitrage is an attempt to exploit differences in capital gains tax treatment between different classes of securities. In some countries, for example, debt instruments that have received certain types of interest payments are subject to taxation up front. In other countries all interest is paid out of after-tax income, with any taxes being deferred until later when the investor sells the security. This means that interest on debt is almost always taxed at a lower rate than dividends. With this “tax arbitrage”, capital structure arbitrageurs can invest in the higher-yielding instrument, receive the income as debt, and convert it to a lower-yielding instrument through the sale of the security.
Martingale trading strategies are based on a simple idea: if you lose money over and over again on a trade, but you’re able to keep doubling your bets after each loss, eventually you’ll come out ahead by sheer mathematical probability. The difficulty is that after each loss, you have to come up with enough money to make another bet, and this in itself can be a risky proposition. The key to success in this regard is borrowing money from someone else. You keep your bet small enough that if you win it will clear off the debt and make you a profit, but if you lose you’ll be able to immediately re-place the bet at double the size using the borrowed cash.
Examples of companies adopting a capital structure arbitrage strategy
Potential bankruptcy costs are uncertainty; accordingly, both creditors and management wish to minimize their potential exposure by holding as little debt as possible relative to every unit of assets. From a creditor’s perspective, the more debt a company has, the greater its likelihood of bankruptcy. From a creditor’s perspective, there is no margin of safety; increasing size only increases downside risk.
However, creditors are not necessarily concerned with the absolute size of both the equity and debt in a firm but only with the relative size: when both equity and debt are high in relation to assets it is more likely that a company will face bankruptcy. Consequently potential bankruptcy is especially important to creditors if they expect a large loss (e.g., due to default).
The capital structure is a balance between the cost of debt and the cost of equity. The greater the proportion of debt in a company’s capital structure, the lower its return on equity. If creditors require a minimum return on equity, then debt should be used to finance only that proportion of assets that will produce higher returns than required by creditors.
For example, suppose that an asset has a beta coefficient of 0.5 and requires an after tax required rate of return (RRR) of 12% in order to be financed by equity; debt allows a financing with a 6% rate as it is at least 1/2 as risky as this asset. The beta coefficient shows that the asset will return 12% * 0.5 = 6% in a year where the economy has had exactly average performance over that period. In a bad year, this asset will underperform; it will return 12% * (1-0.5) = -36% in such a year. The debt financing only allows a maximum of 6% loss in any year, so it is safe to use debt at this level of risk.
If an asset requires an RRR of 14%, then only 2/3rds of that risk can be financed by debt and 1/3rd must be financed by equity.
If an asset requires an RRR of 15%, then it must be entirely financed by equity.
Bankrupt firms can often be financed entirely by debt. The creditors of such firms are likely to experience large losses. Consequently, creditors will be more concerned about bankruptcy if they expect a large loss due to default and are less concerned when they expect a small loss (e.g., if they expect that most of the assets will be sold at recoverable values). Creditors are likely to not be concerned at all, no matter what level of loss is expected.
In the long run, however, the capital structure will “work out” to the desired level of credit risk for the firm’s assets. Since bankruptcy is an unlikely event, the creditors are willing to accept a higher credit risk with a lower expected return in order to gain their desired level of safety. Thus, from the creditors’ perspective, bankruptcy is not an issue.
If a firm’s assets are more risky, then there must be less debt as well. The firm must finance more of its assets with equity, and creditors will be more concerned about bankruptcy. Overall, the creditors’ concerns about credit risk and bankruptcy are inversely related to the risk of assets.
In addition to the benefits described above, shareholders may also find capital structure arbitrage beneficial