The capital structure of International Business Systems Corporation (NYSE: IBM) defines its cost of capital. Analysts use the cost of capital to value the firm. A company with a higher cost of capital has a lower present value. A company with a lower cost of capital, all things equal, has a higher present value. The value of the firm is the present value of cash flows discounted back at the cost of capital. The present value is then divided by the number of shares outstanding, in order to determine a price for the company. In other words, analysts use the cost of capital to determine if stocks are overpriced or underpriced in the market. This is why it is the goal of corporate finance organizations to find the right balance between debt and equity, also known as the optimal capital structure.

Like most companies, IBM’s goal is to find the most optimal capital structure. This refers to the right balance of debt and equity funding that maximizes business operations. From the vantage point of the business, debt represents a cheaper form of financing, especially when rates are low. From the investor’s point of view, too much debt can increase risk by placing a claim on future earnings, even when they decline. The more debt a company carries, the higher its cost of capital, which discounts future cash flows back at a higher rate.

The Cost of Capital

The cost of equity is the required rate of return on equity, including dividend yield and price appreciation. The cost of debt depends on the level of interest rates, the default premium of the business and the firm’s tax rate. It is the rate at which a company can borrow money at today; it is not the interest rate when the debt was issued. The cost of capital is the weighted average of the cost of equity and the cost of debt, and it is the goal of corporate finance organizations to invest in companies that provide a higher return than the cost of capital. Analysts can learn more about IBM's cost of capital and what defines the capital structure by looking at equity capitalization, debt capitalization and enterprise value.

Capitalization Ratios

IBM’s market capitalization dropped from $160.8 billion in December 2014 to $134.4 billion in December 2015. The number of shares outstanding remained flat at 1 billion, which means the value of IBM’s shares declined over the same time period. Indeed, IBM’s stock dropped from $162 in mid-December 2014 to $134 in mid-December 2015. Over that time, the company's debt capitalization decreased slightly from $40.8 billion to $39.9 billion. Short-term debt increased from $5.7 billion to $6.5 billion. Bonds decreased from $39.7 billion to $38.8 billion. For the most part, IBM's debt remained flat. IBM's enterprise value decreased from $219.7 billion to $192.4 billion.

Used primarily by those looking to purchase or buy out a company, enterprise value adds cash to market capitalization and then subtracts debt and pension liabilities. The difference between IBM’s enterprise value of $192.4 billion and its market capitalization of $134.4 billion is total debt, cash and pension liabilities, which were $39.9 billion, $8.2 billion and $26.2 billion, respectively, as of December 2015.

The Bottom Line

IBM has room for growth in its capital structure without exposing itself to unnecessary risk. The market debt-to-equity of IBM’s industry peer group is 35%. IBM’s market debt-to-equity ratio is 30%, which is just under the industry average and not surprising for a mature company such as IBM. While capitalization dropped from 2014 to 2015, this was primarily due to a drop in the stock price rather than a real change in the capital structure, such as a decline in the number of shares outstanding. Additionally, debt remained relatively flat from December 2014 to December 2015, and the cash position remained flat as well. With rates still at historical lows, IBM can afford to take on more debt without increasing its cost of capital.

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