2017: A Year to Review Capital Structure

Prospective tax changes from President-elect Trump will cause companies to change how they allocate and distribute capital.
Reuben Daniels and John R. CryanJanuary 3, 2017

Donald Trump’s tax plan may have the biggest impact on corporate capital structure strategy in the last 30 years. It is time for every company to prepare for what lies ahead. In all likelihood, the Trump tax plan will fundamentally change the way companies raise and deploy capital, and by extension, how they drive corporate strategy and shareholder value.

Among other things, Trump’s “Tax Reform that Will Make America Great Again” plan as described on his website seeks to reduce personal tax rates; reduce the corporate tax rate to 15%; cut the “repatriation tax” to 10%; and phase-in a “reasonable cap” on the deductibility of business interest expenses. Each of these items alone would have a significant impact on capital structure strategy, but taken together the coming change is monumental.

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In addition, interest rates, which are still relatively low, are poised to increase concurrently with the implementation of new tax policy. These changes to our national policies will surely present a host of challenges to companies and finance professionals who will need to revisit their structures, strategies, and policies in order to succeed in the shifting political and economic landscape.

To start, the proposed lower tax rate for repatriated cash will encourage companies to bring upwards of $2 trillion (after-tax) back to the United States. When you consider that in 2015 the members of the S&P 500 combined spent only $1.3 trillion on capital expenditures, cash acquisitions, and research, this number is staggering!

Corporations will be faced with the unprecedented challenge of deciding how much of their offshore cash to repatriate and how to best deploy the money. The sheer magnitude of the cash repatriation inherently increases the risk associated with it; not from a tactical perspective, but from the strategic standpoint of what to do with all that money once it is here.

From a macro perspective, companies have only three real choices for using the repatriated capital:

  • Reinvest the money in the business organically or inorganically;
  • Distribute the money to capital providers through dividends, buybacks, or debt repurchases; or
  • Hold the money for future use.

Most finance professionals agree that investing in projects expected to deliver a return greater than the weighted average cost of capital (WACC) will be the best way to use the money. So, it is safe to assume that corporate investment will increase, but many companies will likely still find themselves with significant excess cash. Therefore, companies may grapple with the questions of how much of this excess capital should be retained for the future; how much should be distributed to capital providers; and how best to distribute the excess capital to owners and lenders to derive the most long-term value.

John Cryan

John R. Cryan Capital structure

Most companies will likely then explore share buybacks and regular and one-time dividends as the next best method of deploying excess cash. However, the proposed reduction in personal tax rates makes the longstanding dividend vs. share repurchase debate even murkier. Proponents of buybacks frequently argue that the difference in tax consequences for investors make a repurchase superior to a dividend. They also contend that repurchases offer greater flexibility than dividends. Lower tax rates and increased excess capital undermine the potency of these points of view.

Trump’s proposed tax rules make it imperative for boards and management teams to closely evaluate and revise their capital distribution policies. Of course, if a company isn’t able to develop its own well-designed and well-articulated financial policies, a host of activist investors will be “licking their chops,” ready to intervene and suggest optimal capital allocation strategies.

The coming cap on interest deductibility, lower overall tax rates, and rising interest rates also mean that companies should reevaluate the mix of debt and equity in their capital structures. Typically, companies use WACC to determine their optimal capital structure. Broadly speaking, when the average company is choosing between two primary sources of capital—debt or equity—it assumes that debt provides less flexibility, increases risk, and is less costly, while equity provides more flexibility and is less risky but is more expensive as a result.

Up until now, the fact that interest is fully tax deductible was a major consideration for companies when assessing the benefit of equity vs. debt. If after-tax costs rise as a result of decreasing tax rates and increasing interest rates, all of a sudden debt becomes less attractive when compared with equity. Consequently, WACC analysis will likely indicate that many companies should have more equity in their capital structures than before. As indicated earlier, most companies use WACC as a key component when evaluating strategic and operating decisions and a material change in WACC could alter their decision analyses.

The challenge is even more profound for companies operating under unique structures like real estate investment trusts and master limited partnerships. Many of these corporate structures are expensive to maintain and provide even less flexibility when it comes to business strategy and capital allocation. Historically, businesses with these structures received favorable tax treatment—when compared with traditional corporate structures—which offset the higher cost. Now, that paradigm is changing, and some companies may find its better to “de-REIT” or “un-MLP.”

Of course, companies cannot make these decisions in a vacuum. Each business should adopt a capital structure strategy unique to its organizational model as well as its short- and long-term goals. Yet, it is easy to see how the Trump tax plan and rising interest rates will have a tremendous impact on financial strategies going forward. The companies that get out ahead of these changes are the ones most likely to prosper.

Reuben Daniels is managing partner and CEO of EA Markets and John R. Cryan is a managing director and head of the strategic equity advisory practice for the firm. EA Markets is an independent investment bank providing comprehensive services focused exclusively in the capital markets.