Rhodytrader has a post up that links to a couple other posts regarding Capital Structure Essentially he joins the discussion with the viewpoint of:
As much as the old methods of financial analysis have come under sharp criticism, there is definitely the question of cost of capital which needs addressing, and that’s something Felix and Joe have ignored. They’ve just harped on the “debt is bad” theme. I understand it given what we’ve gone through, but it risks swinging things in the whole opposite direction, which isn’t any better.
The bottom line is that each company should be making decision about their capital structure that make sense for their particular situation, maximizing the return of their shareholder’s investment, but with a reasonable risk profile.
The cost of capital is an interesting point, and really where I wish to take up the discussion. If we first approach the cost of capital from the point of view of Arbitrage Theory, which undelies the Modigliani – Miller Capital Structure Theory
Along with Merton Miller, he formulated the important Modigliani-Miller theorem in corporate finance. This demonstrated that under certain assumptions, the value of a firm is not affected by whether it is financed by equity (selling shares) or debt (borrowing money).
M&M’s often cited Proposition 1 states essentially that a firm cannot change the total value of it’s securities just by splitting cash-flow claims into different streams.
Two analogies: first, if you have a pizza, if you slice the pizza into six slices or eight slices, do you have any more pizza? The second analogy offers an observation that chicken pieces in a supermarket, often cost more than buying the whole chicken.
Leverage [adding debt] to the capital structure increases returns, and losses to the equity holders, this is so well accepted that I won’t even bother with an example. This is largely due to the reason that in the real world, debt is tax free. All corporate profits allow interest payments to be deducted prior to the paying of any tax, thus debt has a very significant incentive attached to it.
The central point however, as regarding the theoretical valuation, debt will cost exactly the same as equity, if it didn’t, there would appear an arbitrage opportunity.
The kicker in the equation revolves around interest rates. If the interest rate is not being manipulated by a Central Bank, viz. Federal Reserve, then, the cost of capital is equal. However, should the interest rates become manipulated, as they are currently, some very real distortions enter the picture.
Currently, equity prices are still [well] off their highs, making the selling of equity very expensive to the [selling] corporation, while the cost of debt, assuming one can sell debt, is far cheaper, particularly if you have a strong rating, MSFT comes to mind.
Microsoft Corp. Announces Debt Offering
May 11, 2009
Microsoft Corp. announced the pricing of its offering of $3.75 billion of senior unsecured notes. The notes consist of the following tranches; $2 billion of 2.95% notes due June 1, 2014, $1 billion of 4.20% notes due June 1, 2019 and $750 million of 5.20% notes due June 1, 2039. The Company intends to use the net proceeds from the offering for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of stock and acquisitions. The offering is expected to close on May 18, 2009.
This exact problem was encountered after the 1921 bear market that the lower quality companies that did sell debt, found in the business [credit expansion] that ran through to 1929 created the massive boom in stock prices due to the leverage employed, but due to the vulnerable cash-flow ratios, directly contributed to the number of bankruptcies that characterised the Depression. These were created by the lack of appropriate companies willing to optimise their capital structures at  this point in time. Strong companies became so conservative in their capital structure decisions, that it created a dearth of investment grade bond issues.
This creates the very real problem that without the AAA companies converting their capital structure in times of low manipulated interest rates, and thereby absorbing the available liquidity, the door is thrown open to weak companies to speculate within their capital structures. In 2003 when Greenspan lowered the interest rates in the face of a bear market in equities, the cost of capital was seriously distorted, driving marginal lending to firms and others who speculated on the mispricing. Thus, today, we have bankruptcies soaring due to inappropriate capital structures that were never constructed on rational interest rates and cash-flows.
Currently, companies are scrambling to convert commercial paper, short-term borrowing, that was rolled over, essentially providing the spread twixt long-term higher rates, and lower short-term rates, into either long-term debt or equity, as the short-term commercial paper market has shrunk dramatically.
The rising rates for corporate borrowers is now bringing [gradually] the cost of capital back into equilibrium, however, it is at the cost of increasing bankruptcies and rising unemployment.
That the Federal Reserve and other Central Banks continue to try and effect a mispricing in the cost of capital, if they are successful, will lead to another boom/bust cycle.