Just how will American apparel avoid a Halloween fright?

‘Trick or Treat’ has long been a tradition for going from house to house searching for goodies until you’ve taken on too much to carry, which in this case it exactly what American Apparel have done, in the form of debt. As a general principle, companies that have stable sale figures, assets that make good collateral for loans and a high growth rate can use the advantages of debt more heavily than other companies. Recall that the main benefit of increased debt on the capital structure is the increased benefit from the interest expense as it reduces taxable income. Given this statement and American Apparels situation, wouldn’t it make sense to maximize their debt? My answer is no.

In general, using debt keeps profits within the company, increases returns on equity for owners and helps secure tax savings, as well as retaining control of the company.  However, with an increased debt load, interest expense increases and this idea of financial distress becomes apparent. Debt issuers become nervous that company cannot cover its financial responsibilities and this comes no surprise to investors of AA as the company have filed for bankruptcy protection as substantial doubt surrounds the business and investors could incur big losses. So where did it go wrong for the retailer?

AA has high gearing and tried to take on as much debt as possible to increase the value of its company in the long run. As a result, its debt pile grew to 11.6 times its annual earnings before interest, tax, depreciation and amortisation as of March this year, an increase from 8.6 times in 2014. Consequently, it struggled to implement a turnaround fast enough to stem the sharp decline in its stock price, closing at 11 cents on Friday October 2^nd.

Why do you think that the management would allow such a highly leveraged capital structure? In 1963, Modigliani and Miller revised their original theory of capital structure to take into account a more real world approach and incorporated tax into it which showed a substantial benefit to borrowings. On one hand, I can understand why management at American Apparel would highly leverage its capital structure, mainly because the after-tax cost of debt is usually less expensive than equity; so firms will add debt up to the point where the risk of bankruptcy raises the WACC. As a result, the company will favour using debt as a source of its financing when it enjoys a tax shield.

On the other hand, I would look at my first question, how can we know when we’ve maximised our debt? American Appeal should have looked into the market conditions and its own financing before taking on too much debt. MM argues that in the presence of bankruptcy costs, firms should be concerned about having too much debt, this I would agree with. AA could have realised its capability in static trade-off models, which it could have used to maintain its optimal capital structure in the face of market imperfections such as bankruptcy, taxes and debt tax shields.

The current status of Capital Structure research and theory is perhaps best summarised by Baker et al. (2010) “The status of our understanding of how managers actually make capital structure decisions does not appear to be anchored by any of the extant academic theories. Despite several decades of theory development and refinement, none of the normative capital structure theories indicating how managers should act seem to fit the survey data.” This I would agree with as in the real world, managers decisions are altered by the several circumstances. In the case of AA, It depends on various factors such as the type of economic conditions and the time period. In light of the AA situation, maybe it’s time companies actually paid attention to theories, maybe they’d learn a thing or two.