On optimal Capital Structure - are we even asking the right question?

What is the optimal capital structure for a firm?

The entire academic field of finance has wrestled with this question for over 50 years now, and, essentially, gotten nowhere. Perhaps, then, it is time to ask ourselves if we are, somehow, asking the wrong question.

Once we use the language of ‘optimization’, tradeoffs and compromises spring to mind, and we all try to figure out how to balance all of them. When the world of inventory management asked the question – what is the optimal inventory one should hold, it got lost in a quagmire of intricate calculations about reorder quantities and costs of funds – when the correct question to ask was – why do we hold inventory? Which the Toyota Production System asked, and answered in a radical way, because it dared to ask the right question.

In the same vein, instead of asking ‘what is the optimal capital structure for a firm’, perhaps we should ask, instead – ‘what does the firm need funds for?’. Then we may perhaps move to – to finance projects. Very well, then, how should projects be financed? One of the answers may be the parable of the hidden treasure, which I have heard from my friend and colleague #Vraghunathan..

The parable is recounted in my book #Financeatwork but briefly, it goes like this:

If you find a gold coin in your backyard and think there may be a hidden treasure there, how will you go about digging for it? First, you will dig by yourself, in the dead of night if possible.. (the hidden treasure is the project and the act of digging yourself is a metaphor for using internally generated funds). Next, you will go to the labor market and hire some laborers to dig for you, at a fixed rate (this is analogous to taking a loan at a fixed interest rate). If that doesn’t do it, you will call your brother-in-law to help you dig (that is analogous to a rights issue). Only if all else fails, will you issue new equity – why would you want to share your treasure with strangers?!

In my own PhD thesis, I did find, in an unpublished chapter, that firms who finance projects with new equity perform significantly worse than they did before. The fact that their share price goes down the instant they announce it is published in the JFE – all confirming the negative signal of financing a project with equity.

In short, the parable, which asks the question – how will you finance the project? And what signal are you sending by your choice of financing, turns out to be a much more meaningful question to ask than – what is your optimal capital structure?’. Ask, and you shall be answered, but only if you ask the right question!