Is there such a thing as a strong capital structure?

In November 2012, Moody’s cut the triple A-rating of the ESM recuse fund by one notch and gave the rescue fund a negative outlook. The reasons behind this being that the agency felt that ESM would not fulfil its financial obligations. However Moody’s were criticised for their approach by the managing director of the ESM who argued that Moody’s did not acknowledge ESM’s exceptionally strong capital structure. But is there such a thing as a strong capital structure and should this actually make a difference when considering credit ratings?

The traditional view on capital structure argues there is an optimum capital structure at which the WACC is the lowest possible. This is caused by altering the levels of debt and equity within the organisation. But there is no argument to suggest whether this is optimum level equates to a strong capital structure. Having an optimum WACC indicates that up to that point in time, gearing will increase shareholder wealth, whereas anything after this point becomes risky and will see a decrease in share price and shareholder wealth. But does this mean it is strong? Well yes and no. It could be suggested that this optimum point is strong because organisations have been willing to lend to this organisation and have no financial worries about the company, and shareholders have seen potential in the company’s future growth opportunities, but if they are at this point where can they go from here? Is the strongest point therefore not at a point before this optimum level where a company has the opportunity to raise finance from both a debt and equity position?

However, in the 1950s Modigliani and Millar presented a paper which suggested that capital structure has no impact on WACC and therefore no optimal structure exists. So, if no optimal structure exists does a strong structure exist? Well this argument is very similar to that considered in the traditional view. If you are in a position where you are able to finance both through debt and equity without damaging overall value then yes you could be seen to be in a strong position. If your structure does not allow you to finance through debt or equity then it could be argued that you are in a weak position.

Ultimately the conclusion as to whether a company has a strong capital structure or a weak one is dependent upon whoever is making viewing that company at that point in time. A shareholder might argue their company has a strong capital structure when it is providing them with the most wealth; a lending company on the other hand might view a strong structure as one which minimises risk. Therefore it could be seen that Moody’s were right to base their decision excluding an analysis on capital structure as the strength of the capital structure changes depending on who is making the analysis and what their view point is on a strong structure.