Captial Structure: Is there an optimal level?

Optimal capital structures are an interesting (and complicated) area of research.  Personally, I’m quite a fan of the traditional view.  At the risk of sounding like a grumpy old man; back in the day, people seemed to be more sensible.  What happened to the days of companies having a concern for their levels of debt?  Of course, debt is cheap but debt is also constant.  What the good times are here, having a cheap source of capital is great... but what about the bad times?

The traditional approach considered the idea that although debt was cheap, WACC would only decrease to a certain point, where the financial risk was considered to be too high, thus seeing WACC decrease as equity was used as a source of capital.  The optimal capital structure was seen as a delicate balancing act.  ‘Was’ being the key word...

It seems in current times, or at least before 2007, shareholders were content with the risk involved in taking on massive amounts of debt because of the returns they were seeing.  Satisfied that they were maximising shareholder wealth, companies were happy to take on more and more debt.  Then came the point when the ‘credit crunch’ sunk its teeth into a bloated and unsuspecting world.  Suddenly debt finance became impossible as banks collectively panicked over their enormous shortfalls from carelessly loaning out money to any person that could ‘walk and chew gum at the same time’.  Companies like PC World that based their short term cash flow forecasts under the assumption of acquiring cheap debt struggled for survival, and shareholder wealth was obliterated.  Oh for the good old days.

A reason for this blasé attitude appears to stem from the research of Modigliani & Millar (1958), who suggested there was no optimal capital structure, and company value is based on business risk.  The assumptions made in this study were rightfully torn apart by academics, who found the idea of assuming no tax to be laughable.  With nothing being ‘certain but death and taxes’, I’m inclined to agree with the academics.  After a rethink, which included tax, it was found that debt was a significantly cheaper source of capital which would lead to company value being improved if this emphasis on debt was used.

Of course, humans seem to crave an excuse to do something if they can justify it, thus the loading on of debt became almost commonplace.  After the deregulation, which stems from the 1980’s, banks took this opportunity to greater levels which has finally resulted in the chaos we see today.  Only after such a major failure has any action been taken to rectify this, with the introduction of Basel III as an attempt to rectify this problem. 

Personally, although you cannot deny the benefits of debt, the level we have allowed our businesses, governments and ourselves to become reliant on debt is ridiculous.  It is a damning assessment to look at our inability to be sensible and level headed.  As soon as the banks were deregulated, greed seemed to override common sense.  Is there an optimal capital structure?  Most definitely.  Are we anywhere near it?  Looking at the mess we’re in after our love affair with debt, probably not.  Oh for the good old days...