Corporate Finance Theory and Practice, Third Edition

Chapter 36

WORKING OUT DETAILS: THE DESIGN OF THE CAPITAL STRUCTURE

Steering a course between Scylla and Charybdis

By way of conclusion to the part on capital structure policy, we would like to reflect once again on the thread that runs throughout this set of chapters: the choice of a source of financing.

We begin by restating for the reader an obvious truth too often forgotten:

If the objective is value creation, the choice of investments is much more important than the choice of capital structure. Because financial markets are liquid, situations of disequilibrium on them do not last. Arbitrages inevitably occur to erase them. For this reason, it is very difficult to create value by issuing securities at a price higher than their value. In contrast, industrial markets are much more “viscous”. Regulatory, technological and other barriers make arbitrages – building a new plant, launching a rival product, and so on – far slower and harder to implement than on a financial market, where all it takes is a telephone call or an online order.

An industrial business can therefore hope to find a strategy that secures it an economic rent – that is, a strategy that enables it to earn a return on investment higher than the required return adjusted for risk. If it can do so, it will create value. But let it harbour no illusions as to permanence: sooner or later, that rent will erode and disappear.

In other words, a company that has made investments at least as profitable as its providers of ...