There is a strong argument on the exist of the optimal structure. Some people suggest that there is an optimal structure in the capital structure, which could help the organization to create more shareholder wealth; while others believe that there is no optimal structure as the change of the capital structure has no effect on the company’s WACC so it do not exist. However, since this was based on the assumption, it only could be used under certain condition. Therefore, it is still difficult for the manager to control the capital structure. From my personal view, I do believe that the capital structure has kind of relationship with the shareholder wealth, which could be proved through the case below.
Like the company Peacocks, which is a clothing retail has gone into administration because of the unsuccessfully to restructure its £240m debts from its total debts. Moreover, based on the figure of the year 2010, it could be found that the debts becomes a burden for the company. It used to make operating profits of £27m, however that was reduced to a pre-tax loss of £56m as a result of £77m in bank loans and overdrafts. Therefore, the high cost of finance make the company go administration. The reason for Peacocks has so much high finance cost is because of the change of capital structure at wrong time. The manager choice to management buy out through the bank loan, which make the company has £460m bank loan in order to reduce the share capital to increase the power of manger. Since the recession continue, it could be found that the bank loan is high interest which make the company has overall debts stands at £750m in 2011. As we know that, during the recession, it could be better to choice the share equity, since the company has no need to give the dividend and the higher bank interest based on the higher risk. Hence, it could be more wise for the company to choice go for the share equity.
Moreover, the Peacocks now sold to Edinburgh Woollen Mill since the company could not going concern with such high debts. From this case, it could seen the shareholder wealth has been destroyed by the wrongly choice on the capital structure. Moreover, it tells that we need to taking the environment into consideration, if the timing is good, it could be found that sometimes it is more cheaper to choice debt finance like when the government trying to encourage their economic it reduce their bank loan interest, which for the company is a good news to reduce their cost of finance. However, during the financial crisis, as it could be know that the credit crunch, the credit was so high as people are not willing to lend their money and the government bank also increase their rate of reserve. In this time of period, lending is at a extremely high cost.
Therefore, it could be found that in the economic growth period, the debts finance is better and during the recession period the equity and debts finance need to be carefully considerate. The manager need to careful balanced the capital structure in order to create more shareholder wealth. As the lower cost of finance could reduce the expense,which in some extent is increasing the shareholder wealth and the unhealthy capital structure might the company go administration the the company Peacocks.
http://www.bbc.co.uk/news/uk-wales-16733819
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