Blog 9: Striking a balance between dedts and equities

As I have talked in previous blogs that there are several approaches to financing a company, namely raising equity and borrow bonds. However, debates on whether shareholders’ wealth can be improved through the way on how to financing their companies are always a hot topic for arguing. Traditional views toward the structure of capital mainly focusing on debt, in that it enjoyed a much lower cost when compared with equity. Nevertheless, it is rational for thinking that if a company suffered a huge amount of debts, their shareholders may worried about the risk of going to bankruptcy. That is one of the reasons for Schaeffler Group planning to reduce its massive debt load by selling some of its stakes.

Schaeffler Group is a ball-bearing maker in Germany; this company refinanced their capital structure through selling its shares on Continental which is an auto supplier in Germany. What surprised me most is Schaeffler Group using their selling proceeds to buy Continental shares, what’s more, in order to own 49.9% stakes in Continental, Schaeffler Group buy an additional 15.5 million shares from the banks who also owns lots of shares in Continental (Wall Street Journal, 2011).

The reason to why Schaeffler Group wants to change their debt structure to shares in Continental may probably lies to their consideration on shareholder wealth. In my opinion, stakes of 49.9% mean a potential control in Continental, to some extent, it is better for shareholders in Schaeffler Group enjoyed a high synergy from those potential merge than pay debts interests to Continental every year. Therefore, it is seems that this refinanced capital structure can be regarded as a creator for shareholder wealth, isn’t it?

However, according to Modigliani & Millar’s theory, shareholder’s wealth has noting to do with the financing approaches, it is business risks and business prospects that matters for creating shareholder wealth. Indeed, the calculation seems reasonable as the total value of the firm remains the same regardless of their different financing methods. Nevertheless, MM Models are based on several unpractical assumptions which are probably unsuitable for some certain situations. As a rule of thumbs, MM Models based on static analysis instead of developed views, to be more specifically, the ignorance of economic environment and changes in companies’ own financial situations lead MM Model only considering some short-term effects on company’s capital structure. For example, companies are required to relieve their debts in order to get rid of the risk on bankruptcy especially when the company suffered a financial crisis. Hence, like I have talked in last blog, academic theories can act as guidance for companies to refer, however, they are suggested to relate theories with their own practical performance rather than use theories blindly.