Capital structure: De Beers plans to cut debt

BBC (2009) stated that De Beers plans to raise its capital investments from investors to $1billion to reduce its debts. I think about my previous lecture topic’s capital structure. If the low level WACC of project presents high level of present value of future cash flows thus shareholders’ wealth is increasing, it will be beneficial to company with high level of debt. As the debt level increases, the actual cost of loan to the company is lower because the interest on the debt is deduced. Moreover, lenders does not share profits to company’s profit. They only require a fixed amount of interest annually. In addition, lenders do not dilute ownership interests and control of existing shareholders. In general, the cost of debt financing is cheaper than equity financing.

However, why De Beers plans to increase equity instead of debt? The problem incurs because of advantage of debt compared to equity which is company only has to pay a fixed amount of money and doesn’t have to pay any extra amount of money when company makes profit. Problem is what about when company makes lose? Company still has to pay that amount of money without any discount. De Beers experiences a bad year in which first-half profits fall by 99% as a result of a collapse in the price of diamonds. How can De Beer pay for the interest of current amount of debt ($3.5bn) while it has financial trouble? In this case, I think the De Beers’ s decision to increase level of equity is right. According to the case, it remind me about the advantages of equity compared to debt, during difficult financial periods, high level of equity can avoid company from risk because equity financing does not require to be paid. Moreover, the larger level of gearing, the more risky lenders and shareholders consider company. Lenders and shareholders would require more interest and dividends to guarantee their interests.

The lesson is that high gearing level is not always is the goods options. There is no perfect capital structure fomula applying to all project and company in imperfect world. In term of diversification approach, company should raising capital by both equity financing and debt financing because the two forms of financing together can work well to reduce the downsides of each. However, working to find out the right ratio is every difficult in order to maximize shareholder wealth. Depend on particular situation; company might decided the suitable capital structure to fit with the requirements. It will vary according to various aspects such as: type of business, revenue and profits, cash flows and a mount of money need to be financed.

Source:

http://news.bbc.co.uk/1/hi/business/8387839.stm