What should a firm do when it finds that its desired capital structure differs significantly from its current capital structure? There are two basic choices: change its capital structure slowly or change it more quickly. A firm can alter its capital structure slowly by adjusting its future financing mix appropriately.
For example, suppose a firm’s target capital structure consists of 35% long-term debt and 65% common equity, and its current capital structure consists 25% long-term debt and 75% common equity. The firm could cure the under leveraged condition by using long-term debt for all new external financing until the long-term debt ratio reached 35%. However, this means that the firm’s capital structure would continue to be “suboptimal” while the firm changed it over time.
Alternatively, the firm can change its capital structure quickly through an exchange offer, recapitalization offer, debt or share repurchase, or stock-for-debt swap. Of course, such a quick change is not without cost either. The firm will incur transaction costs, and there will be signaling effects associated with the change.
If the difference between a firm’s actual capital structure and its target corresponds to one full rating category or more, some type of one time transaction to make an immediate change in capital structure is probably warranted. A leverage increase for a significantly under leveraged firm is likely to increase he firm’s share price. If the firm is less than one full category away from its rating objective (for example, it is a weak single A and wants to come a strong single A), altering its retention ratio and its external financing mix is probably most cost effective.