Financial Strategy :Capital Structure by Ehab AbuSabha
1- Introduction
2-
Capital Structure
3-
Determinants of capital structure
3-1 Optimal capital structure
3-2 Debt and equity mix
4- Factor Determinants of capital structure
4-1 Gearing
4-2 Risk
4-3 Timing
4-4 Return
4-5 Control
4-6 Flexibility
4-6 Profitability:
4-7 Shareholder Value
5- Conclusion
6-
References:
1- Introduction
The mixture of debt and equity maintained by a firm.is called capital structure . (Ross. P38).
the financial director of s firm has two views in this area how much should the firm borrow? And what are
the least expensive sources of funds for the firm? Financial director has to focus on
risk-return relationships and the maximization of return for a give level of
risk.
financial director will do his best to choose a firm’s
debt-equity ratio that maximizes the value of a share of stock. The major financial decisions made by the managers of a business are
either investment decisions or financing decisions. The major function of the
financial director is to ensure that the business has sufficient cash to enable
payment of its obligations as they become due. In addition to decisions about
the composition of investments, they have to decide how to finance their
financing decisions. The financing decisions involve generating funds either
through internal or external. External generation is done by issuing debt or
equity securities (graham,p3-4).
As a financial director of a company, has to submit a plan to the board of directors regarding the
future financial strategy by taking into account the financial theories like
M&M.
The start will be by
design a capital structure in the light of two propositions, First the
capital structure be designed in such a way so as to lead to the objective of
maximization of shareholders wealth, second The exact optimal capital structure
may be impossible and therefore, efforts be made to achieve the best
approximation to the optimal capital structure.
In practice, firms differ from
one another in size, nature, earnings, cost of funds, competitive conditions,
market expectations, risk etc. Therefore, the theories of capital structure may
provide only a broad theoretical framework analyzing the relationship between
leverage and cost of capital and value of the firm. A financial director
however, should go beyond these considerations as no theoretical model can
incorporate all these subjective features.
2- Capital Structure
Optimal capital
structure is capital structure that
maximizes the value of the company
overall ,All companies are subject to business risk for e.g. New
competitor came to the market , new government regulations may be introduced,
new technology came etc. these and other factors contribute business risk which
will be reflected in changes in the firm’s net operating cash flows.
When a firm uses debt finances as well as
equity, the shareholders are exposed to higher risk. This results to the fact
that payments to lenders are fixed. Therefore the risk faced by the
shareholders is directly related to the proportion of debt in the company’s
capital structure. The risk borne by the shareholders as a result of financial
leverage is known as financial risk which can be represent as :
Total risk = business risk +financial risk
The
degree of financial leverage the firm chooses to employ. This will determine
the
amount of borrowing the firm will use to finance its investments in real
assets. On the other hand Leverage results from the use of fixed cost assets or
funds to magnify returns to the firm’s owners. Increase in leverage results in
increased return and risk, whereas decrease in leverage result in decreased
return and risk. The amount of leverage in the firm’s capital structure can
affect a firm’s value by affecting the return and risk. Because of its effect
on value, the financial director must understand how to measure and evaluated
leverage when making capital structure decisions. (gitman, p467)
Financial leverage results from the use of fixed payment
financing such as debt and preference shares to magnify return and risk.
3- Determinants of capital structure
Using Modigliani and Miller theory deciding
the financial strategies in the capital structure of a company help a lot because of
M&M is one of the foundations of
modern finance. It states that corporate financing decisions do not affect firm
value under certain conditions. One of the key assumptions underlying this
proposition is that financing and investment decisions are separable and
independent. When this assumption holds, various financing decisions such as
the firm's capital structure, its ownership structure, and its board structure
do not affect firm values or investment decisions. This mean , financing
structure does not matter. On the other research in the field of corporate
finance over the last 25 years has attempted to show that financing structures
do matter. M&M analyzed the effect of
capital structure on company value based on a set of assumptionsWhich are:
- Perfect Capital Markets
- Companies and individuals can borrow at the same interest rate.
- There are no personal or corporate taxes.
- There are no costs associated with the liquidation of a company.
- Companies have a fixed investment policy so that investment decisions are not affected by financing decisions
.
M&M uses three propositions
Proposition 1:
One way to
illustrate M&M Proposition I is to imagine two firms that are identical on
the left-hand side of the balance sheet. Their assets and operations are
exactly the same.
The right-hand
sides are different because the two firms finance their operations differently.
In this case, we can view the capital structure question in terms of a pie”
model ,gives two possible ways of cut the pie between the equity slice, E, and
the debt slice, D: 40%–60% and 60%–40%. However, the size of the pie is the
same for both firms because the value of the assets is the same. This is
precisely what M&M Proposition I states: the size of the pie doesn’t depend
on how it is sliced.
Figure 1 (Ross,575)
Proposition 2 (Without
Taxes): changing the capital structure of the firm does not change the
firm’s total value, it does cause important changes in the firm’s debt and
equity The
cost of capital would increase with the introduction of cheaper debt capital by
an amount exactly equal to the value of the cheaper debt capital
Proposition 2 (With
Taxes): The Value of the levered firm will increase by the present value of the
tax shield on debt thus there is an incentive for the firm to increase the
sources of debt.
Figure 2 (Ross,576)
Proposition 3: The
discount rate used by the firm for a particular investments proposal is
independent of how the proposal is to be financed. The appropriate discount
rate depends on the features of the investment proposal i.e. the riskness of
the cash inflows received from the investment. (Graham, P391)
In a perfect market with no taxes, risk free debt and investors are able to borrow at the corporate rate then the value of any firm will be the residual cash flow divided by the cost of capital .With the introduction of Corporate Taxes and the tax deductibility of interest payments on debt the value of the levered firm will increase by the present value of the tax shield on debt thus there is an incentive for the firm to increase the sources of debt. The logical conclusion would thus be to have firms with 100% debt.
M&M state that total risk for all security holders of a company is not altered by changes in the company’s capital structure. Therefore the total value of the company must be the same regardless of the company’s financing mix. M&M position is based upon the idea that no matters how you divide up the capital structure of a company among debt, equity and other claims. The company value is unchanging according to changes in capital structure. Thus the total value of pie does not change as it is divided into debt, equity and other securities. So regardless of the financing mix the total value of the company stays the same. (Van Horne, p566-567)
3-1 Optimal capital structure
It is based on balancing
the benefits and the costs of debt financing, the major benefit of debt
financing is the tax shield, which allows interest payments to be deducted in
calculating taxable income. The cost of debt financing results from Increased
probability of bankruptcy caused by debt obligations and The agency cost of the
lenders monitoring the firms actions in addition The costs associated with the
mangers having more information about the firm’s prospects than do investors
(Gitman, p479)
The probability of
bankruptcy due to an inability to meet its obligation as they come due depends
largely on its level of both business risk and financial risk.
Business risk as the
risk to the firm of being unable to cover its operating costs. The greater the
firm’s operating leverage the use of fixed operating costs the higher its
business risk. Other two factors that affect business risk are revenue
stability and cost stability. (Gitman, p479)
3-2 Debt and equity mix
Debt capital includes all long term borrowing incurred by
the firm, including bonds.
Equity capital consists of long-term funds provided by
firm’s owners, the shareholders. Equity capital can be raised internally
through retained earnings or externally by selling ordinary or preference
shares. (Gitman, p37).
The debt position of a firm indicates the amount of other
people’s money being used in attempting to generate profits. The financial directors are more
concerned with non-current debts, since these commit the firm to paying interest
over the long term, as well as eventually repaying the principal borrowed.
Lenders are also concerned about the firms degree of indebtedness and ability
to service debts, since the more indebted the firm, the higher the probability
that the firm will be unable to satisfy the claims of all its creditors.
The more debt a firm uses in relation to its total assets,
the greater its financial leverage. i.e. the greater will be its risk and
return .( Gitman ,p112).
If there is no tax, the firm’s net operating income is
distributed between equity holders and debt holders, and the trade-off
associated with changes in leverage is between the returns required by equity
holders and debt holders.
4- Factor Determinants of capital structure
4-1 Gearing
The traditional
view is that there is an optimal capital structure. As gearing increases so financial risk
increases because the fixed charges increase.
In the previous
no-tax case the advantage of gearing-up (a lower cost of debt capital)
therefore an increased kE). The introduction of taxation brings an additional
advantage to using debt capital: it reduces the tax bill. Now value rises as
debt is added to the capital structure because of the tax benefits (or tax
shield). The WACC declines for each unit increase in debt so long as the firm
has taxable profits. This argument can be taken to its logical extreme, such
that WACC is at its lowest and corporate value at its highest when the capital
of the company is almost entirely made up of debt
4-2 Risk
A firm's capital structure must be
developed with an eye towards risk because it has a direct link with the value.
Risk may be factored for two considerations:
The capital structure must be consistent with the business risk,
and The capital structure results in a
certain level of financial risk.
Business risk may be defined as the
relationship between the firm's sales and its earnings before interest and
taxes (EBIT). In general, the greater the firm's operating leverage-the use of fixed operating cost- the higher its
business risk. Although operating leverage is an important factor affecting
business risk, two other factors also affect it-revenue stability and cost
stability. Revenue stability refers to the relative variability of the firm's
sales revenues. This behavior
depends on both the stability of demand and the price of the firm's products.
Firms with reasonably stable levels of demand and products with stable price
have stable revenues that result in low levels of business risk. Firms with
highly volatile product demand and price have unstable revenues that result in
high levels of business risk. Cost stability is concerned with the relative predictability of input price. The
more predictable and stable these
input prices are, the lower is the business risk, and vice-a- versa..
Factors determining the Amount of Debt
4-3 Timing
market timing is an important determinant
of observed capital structures. The market timing (or windows of opportunity)
theory posits that corporate executives issue securities depending on the
time-varying relative costs of equity and debt, and these issuance decisions
have long-lasting effects on capital structure because the observed capital
structure at date t is the outcome of prior period-by-period securities
issuance decisions.
According to the
market timing theory, firms prefer equity when the relative cost of equity is
low, and prefer debt otherwise. The capital structure literature has, to date,
refrained from explicitly measuring the cost of equity.
4-4 Return
The financial
manager’s responsibe to raise the money
to pay for the investment in real assets ,This is the financing decision. When
a company needs financing, it can invite investors to put up cash in return for
a share of profits or it can promise investors a series of fixed payments. In the
first case, the investor receives newly issued shares of stock and becomes a
shareholder, a part-owner of the firm. In the second, the investor becomes a
lender who must one day be repaid. The choice of the longterm financing mix is
often called the capital structure decision, since capital refers to the firm’s
sources of long-term financing, and the markets for long-term financing are
called capital markets.
4-5 Control
The ultimate decision making power of the
firm lies in the hands of equity shareholders, therefore, the issue of
additional shares can affects who controls the firm. A management concerned
about control may prefer to issue debt rather than equity shares to raise
funds. A capital structure of a firm should be one, which reflects the management's
philosophy of control over the firm.
4-6 Flexibility
The flexibility of a capital structure
refers to ability of the firm to raise additional capital funds whenever needed
to finance profitable and viable investment opportunities. The capital structure should be one, which enables the firm
to meet the requirements of the changing situations. More precisely,
flexibility means that a capital structure should always have an untapped
borrowing powers which can be used in conditions which may arise any time in
future due to uncertainty of Capital market and Government policies.
4-6 Profitability:
A capital structure should be the most profitable
from the point of view of equity shareholders. Therefore, within the given
constraints, maximum debt financing which is
generally cheaper should be opted to increase the returns available to
the equity shareholders. In addition, an analysis of rate of return on total
assets and the cost of debt may be made. If the rate of return on total assets
is more than the cost of debt then the financial leverage may enhance the
returns for the equity shareholders. In our case as existing firm may require
additional capital funds for meeting the requirements of growth, expansion,
diversification or even sometimes for working capital requirements.
Every time the additional funds are required, the firm has to evaluate various
available sources of funds Compared with the existing capital structure.
4-7 Shareholder
Value
As we said before the capital structure to be designed in such a way so as to
lead to the objective of maximization of shareholders wealth,
5- Conclusion
In designing the capital structure for any firm, the
first major policy decision facing the firm is that of determining the
appropriate level of debt. For most of the firms, the decision involves a
choice between the long-term debt and the equity. The firm's debt capacity may
be best defined not as the maximum amount which the lenders or debt investors
are willing to lend to the firm, but as the amount of debt that the firm should
use.
The choice of an appropriate financing mix involves
basically a trade-off between tax benefits and the costs of financial distress.
The optimal debt level depends to an important extent on the operating risk of
the firm. The greater the operating risk the less should be the degree of
financial leverage. Low debt-repayment ratios
are associated with high degrees of financial leverage. The more risk a firm is
willing to take, the greater its financial leverage. The firm should maintain
financial leverage consistent with a capital structure that maximizes owner’s
wealth. (Gitman, p478)
It analysis the effect of capital structure on rates of
return to investors. In a perfect capital market the expected net operating
cash flow depends only on the profitability of the company assets and is not
affected by the company’s capital structure. This means the value of the
company will also not affected by its capital structure. It follows that the
choice of capital structure dose not affect the expected rate of return on the
company assets. The probability of the costs of financial distress
increases with financial leverage, particularly if the leverage is achieved
through a variety of financing method that have the potential for increasing
the number of lawsuits and associated costs
The ideal
mixture of debt and equity for a firm , its optimal capital structure which
focus on maximizes the value of the firm and minimizes the overall cost of
capital
6- References:
1.
Graham
Peirson Rob Brown, Steve Easton, &Peter Howard, 2003,’Business Finance’, 8th edn, Irwin
McGraw-Hill,Australia.
2.
Ross,
Stephen A., Westerfield, Randolph W., Jordan, Bradford D., 2000 ’Fundamentals of Corporate Finance’,
first edn, Irwin McGraw-Hill, New York.
3.
Mehran, H. 1992. Executive
incentive plans, corporate control, and capital
structure. Journal of Financial And
Quantitative Analysis. 27 539-560
4.
R.
Brealey and S. Myers, Principles of Corporate Finance, 7th edition,
Irwin/McGraw Hill.
5.
Vanhorne,
Davis, Wachowicz, & Lawriwsky, 2000,’Financial
Management and Policy in australia’, 4th edn
6.
Gitman,
Juchau, & Flanagan., 2002,’ Principles
of managerial Finance ‘,3rd edn, Addison Weseley, Australia.
