Capital Structure the Optimal Capital Structure Depends

Capital Structure

The optimal capital structure depends on a number of factors. The nature of the business that the company is in is important, in particular the fluctuations in the company's cash flows. The company should also consider the time frame for which the capital is being used. In addition, the optimal capital structure also depends on the degree to which the company is willing to cede control, and the cost of capital that it desires (Kennon, 2011). Thus, for every different firm there will be a different optimal capital structure.

Mattel is in a stable business, its revenues ranging between $5.4 and $5.9 billion in each of the past five years and its net income fluctuating between $379 million and $684 million during that same period (MSN Moneycentral, 2011, 1). This high level of predictability in the firm's business means that it can handle a high degree of leverage. The financing cost of debt is lower than the cost of equity, which is appealing to a company like Mattel. Its projects are likely to be short-term in nature because Mattel is not oriented towards the type of long-term growth model that would encourage the use of equity as a means of financing its business. Mattel's current capital structure is 49.5% debt and 50.5% equity, oriented probably more to equity than it needs to be, but it has remained stable at this structure for the past three years.

Clorox is in a similar position to Mattel. Its business is mature and its revenues are relatively stable, although there is a little more growth in Clorox's revenues. The company's net income shows stability in profits as well (MSN Moneycentral, 2011, 2). For a mature company with little growth, Clorox can orient itself towards debt in order to lower its cost of capital. Something in the range of 60% debt would be appropriate. Clorox's current capital structure is discouraging -- the company has negative equity. There is no need for a company with stable earnings and cash flow to have negative equity.

MGM International has faced declines in revenue and net income in recent years. Its business appears, therefore, to be more volatile in particular with the state of the economy in general (MSN Moneycentral, 2011, 3). Higher volatility implies less debt is preferential. In addition, given the life span of resort investments, debt is the more appropriate means of financing, especially ten and twenty year debentures, so that the property can pay for itself over this time period. MGM should also be able to generate sufficient profits to use equity for some of its investments, however, especially given the challenges in the economy. A capital structure with only around 30% debt is recommended for MGM International. The current capital structure is currently around 84% debt. This reflects the company's rapidly declining equity base (down 50% in the past three years) but also its reliance on debt financing. Given the nature of the projects, a high debt level makes some sense, but only if the revenues are not volatile. MGM is taking on too much debt for a firm with cyclical earnings.