Establishing Capital Structure Objectives
THE CFO'S SKILL IN MANAGING the capital structure can have a material impact on a company's cost of capital and can make the difference between financing strategies that are appropriate for a company versus those that cross the line of prudence. As became abundantly evident in the recent financial crisis, the effectiveness of the CFO's management of the capital structure literally can determine a company's life or death as a going concern—obviously a responsibility that should not be taken lightly.
The capital structure is also fundamental to accomplishing the company's strategic and financial objectives: The financing decisions must be in sync with the investment decisions.
One of the most important decisions is the establishment of debt leverage targets, which provide the underpinnings for the company's financing strategies. CFOs usually express their debt leverage targets in three different ways: a cost of capital assumption, company-specific leverage ratios, and a debt ratings objective.
Cost of Capital Assumption
The most fundamental of the leverage targets is the ratio between the market value of a company's equity securities and its total market capitalization. This is the ratio that is used in the capital asset pricing model to determine the company's weighted average cost of capital; it represents the target capital structure for financing the company over the planning horizon (say, the next five ...