Where did Peacocks get it wrong?

Optimal capital structure is the concept that a company can benefit from continuing to increase its debt through financing. As the gearing level continues to increase, the cost of the financing can actually begin to decrease. Companies have to be careful and try to avoid creating too much debt as the consequences can be drastic.

Peacocks has been in financial turmoil since last year and as a result of this the company ended up in administration. Recently the company came out of administration as it was sold to Edinburgh Woollen Mill. From this purchase 6,000 jobs were saved but 3,100 members of staff were made redundant (BBC News, 2012). How did Peacocks end up in this mess in the first place and why were the problems not prevented earlier?

Like many other companies, Peacocks suffered from the decrease in spending by customers during tough economic times. Mr Pope, joint administrator and associate partner at KPMG, suggested that the company also had “a surplus of stores and unsustainable capital structure” (BBC News, 2012). This comment suggests that it is possible for companies to take on too much debt therefore exceeding optimal capital structure. This is one factor towards why some companies have gone into administration in recent years. Peacocks went into administration in January 2012 as it failed to restructure £240m of its £750m debt (Financial Times, 2012). The levels of debt spiralled out of control and therefore the capital structure of the company collapsed.

Lots of companies become geared by borrowing money and building up debt. This can actually have a favourable effect on share prices. Maximising shareholder wealth is very important to most companies which may be why so many become highly geared. There is also a risk to shareholders in the long term and this should be taken into account. If their invested company begins to falter then the interest payment may become difficult to pay. The interest payments will remain the same even if a company begins to produce less profit. Peacocks could not make the necessary payments on the £750m debt as they were not producing the profits that had been expected.

Modigliani and Millar (1958) proposed an alternate theory to optimal capital structure. They suggested that there was no such thing as optimal capital structure and that the value of a company related directly to the risks to the business. If this concept were true then this would mean that many companies, including peacocks, may have altered their capital structure on false pretences.

Companies cannot just expect to be successful on a regular basis. Almost every company has moments when it may struggle; these factors may be an external effect that a company cannot control. Peacocks struggled because of the economic downturn. They probably did not envisage that spending would decrease as much as it did; this is a sign of over optimism. Companies such as Peacocks have to be more realistic in what can be achieved in the short term and the long term. If a company folds then many people suffer. Customers lose products they liked, shareholders lose investments and members of staff lose jobs as shown in the picture above. Companies need to be aware of the financial risk to the company for each proportion of debt that is attained. It is ok for companies to finance debt as long as it is within moderation. Each company should set itself a maximum gearing percentage that it can reach. This would hopefully avoid companies relying on this form of money too much and therefore survive in challenging times.  

Sources used:

BBC News

Financial Times

Modigliani and Millar