Introduction
Dear Board of Directors,
In this paper I started my analysis with the
theoretical theories that implies on the capital structure with assumption of a
perfect market affected by different debt/ equity ratio. Then I started adding
the Practical considerations which had important consequences on the firms’ Capital
structure choice.
I had
developed a theoretical and practical approach that relates a firm’s
capital-structure choice to the future financial strategy under which it
operates. I showed that optimal capital-structure choices depend on not only one
factor of practical variables like tax or bankruptcy but also to other major
impacted factors like the firm’s asset-specificity: firms with high asset-specificity
will use a higher degree of leverage under an equity-friendly bankruptcy than
under a debt-friendly code, but the reverse is true for firms with low asset specificity.
As a
conclusion there is no universal theory of capital structure, and no reason to
expect one, There are useful conditional theories , like M&M and trade off
theories , however each practical factor could impact a firm from another
depend on different circumstances.
Best
Regards,
Financial
Manager
Capital Structure
Before we start analysing the
theories and applying the practical factors to it we need to understand and
answer the following questions: What are the sources of capital/financing
needs? What are the advantages and disadvantages of each? What is the optimum
financing Mix /structure?
There are 3 types of financing:
(equity) own pocket, (debt) Banks and Preference shares (debt + equity).
Capital structure is the optimum
way managers select the mix of equity, debt and preference shares.
Equity: funds generated by the
business injected by owner.
Ex: family owned companies are
100% equity.
How to raise equity? By IPO,
Private invitations by raising the equity you are additionally brining more
control.
Equity Return is high to
compensate the high risk. Equity holders have more rights than debt holders
where they have the right to vote.
Debt:
Specific obligation to pay the bank, the funds you owe the banks and this will
need disclosure of more info and the more info managers give, it will decrease the
firm’s competitive advantage and manager’s control.
Debt return is the interest
rate on debt when the principle is due, then this money will be paid to the creditors.
Interest rate could be fixed or
floating depends on the market, it will depend on the project/idea, in case of future
ideas will have higher risk and then higher interest rate.
Debt holders (creditors) will
not share in the value created by growth, claim only on the interest and
principal, they don’t vote.
Cost of debt Kd = Cost of
financing Interest on Debt
Cost of Equit Ke = rf + β (ru –
rf)
Cost of Capital WACC = D/V Kd (
1 - tc) + E/V Ke + P/V Kp
Financial Theories
In This part I will accurately
analysis the current financial theories available and decide which guidance can
it make to my financial strategy decisions.
Proposition 1
M&M
proposition 1 based on Assumptions been met if any of the assumptions not hold
the theory doesn’t hold.
Assumptions
are:
- Capital markets are perfect.
Access to Information should be
available to everyone.
Symmetric, Complete Information,
outside investors have the same information that managers have.
- Companies and individuals can borrow at the same interest rate
The
risk of debt should be fix which means debt should be risk free.
This means that individual investors
can undertake any sort of levering or unlevering transaction that firms can
take.
An
example of this will be that a small unknown investor should borrow money from
the Bank with the same interest rate as IBM or BP.
- There are no taxes.
This
will be applied on both individuals and corporate.
- There are no costs associated with the liquidation of a company.
No
transaction cost will affect investment decisions
- Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.
This
means that in our analysis of capital structure choice, we are assuming that
the firm is not using the proceeds from raising capital for any purpose. It is
simply issuing equity to pay down debt, or issuing debt to pay down equity.
If all
the above assumption holds then:
“The value of a firm is independent
of its Capital Structure. In Perfect market any combination of securities is as
good as another. The value of the firm is unaffected by its choice of capital
structure.” (Brealey/Myers/Allen, 8th edition)
Some books call it irrelevance proposition which means
that the value of the firm is independent of its capital structure, and is
given by the capitalized value of the assets, capitalized at the asset return.
Assume that two firms with the same cash flows X1 and
X2 have different capital structures, and assume that firm 1 is more highly
levered.
Then we show that it cannot be that V1 > V2, since
if this were the case one could create homemade leverage in V2 and arbitrage
the difference in value.
Likewise, it cannot be the case that V2 > V1 since
then it would
be possible to artificially unlever V1 and keep the difference
as arbitrage profits.
So The law of conservation of
value Hold:
VL= VU
The earning power of the assets
is the key issue NOT the method of financing the assets which ultimately
affects the distribution of the cash inflows from the assets.
Perfect substitutes cannot exist
in the same market at different prices.
If firm value was a consequence
of the capital structure then the arbitrage process would be exploited to take
advantage of different values.
You should not pay/evaluate the
firm based on the capital structure.
Proposition 2 (Without Taxes)
“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.” (Brealey/Myers/Allen, 8th
edition)
The second proposition of
M&M will stand on similar assumptions of proposition II which is:
A
perfect market context, no taxes, risk free debt and Individuals Investors are
able to borrow money at the same corporate rate from banks.
As
those assumptions hold then the cost of equity in an all equity firm will
increase with the introduction of debt due to the introduction of financial
risk.
As
the Total Risk = Business Risk + Financial Risk
AS
the dept is cheaper then the interest rate paid to the bank is irrelevant to
the lose or win of the company and the creditors will have the priority to be
paid in case of lose (Bankruptcy).
Due
to that the cost of equity will increase the return of equity holders will
increase to compensate them for the financial risk that they will take.
ke = k*e +
(k*e – kd) D
E
EXPECTED
RETURN ON EQUITY = EXPECTED RETURN ON ASSETS
+ (EXPECTED RETURN ON ASSETS-EXPECTED RETURN
ON DEBT) x DEBT/EQUITY RATIO
The
expected rate of return on Equity of a levered firm with cheap debt will
increase in proportion to the debt-equity ratio (D/E). This increase is offset
by the increase in risk and therefore in shareholders’ required rate of return.
Increase
in leverage in creases amplitude of variations in cash flows available to
shareholders same change in operation income now distributed among fewer
shares.
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.” (Brealey/Myers/Allen,
8th edition)
An introduction of Corporate
Taxes and the tax deductibility of interest payments on debt assumption on the second M&M’s
proposition will lead to an increase by the present value of the tax
shield on debt therefore there the firm will befit from increasing the source
of debt. The increase of the debt will be up to a level where you don’t threat
your company by bankruptcy.
VL= VU + PV (tax shield on
debt)
As PV (TAX SHIELD) = Tax Rate x
Interest Payment / Discount Rate
= TC (rDD) /rD
= TC D
Discount interest tax shield at
expected rate of return demanded by investors holding firm’s debt.
Value of levered firm increases
by PV (TAX SHIELD) provided for interest payments.
Proposition 3
“The discount rate used by the
firm for investments is independent of the methods used to finance the
investment. The discount rate used should reflect the riskiness of the cash
inflows received from the investment.” (Brealey/Myers/Allen, 8th
edition)
Trade off theory
The theory
is based on that capital structure is based on a trade-off between the tax
savings (tax shield) and the financial distress costs of debt. The more debt,
the higher tax shield benefit, the higher the financial distress and probability
of your firm bankruptcy.
Firms with tangible assets tend
to have more debt as banks are willing to give debt unlike risky intangible
assets companies which have to depend on equity.
Issuing common stock drives
down stock prices; repurchase increases stock prices. Issuing straight debt has
a small negative impact.
Pecking order theory
“Starts with
asymmetric information; manager know more about the company than the outside
investors.
This asymmetric information
affects the choice between internal and external financing and between new
issues of debt and equity securities.” (Brealey/Myers/Allen, 8th
edition)
The announcement of a stock
issue drives down the stock price because investors believe managers are more
likely to issue when shares are overpriced. Therefore firms prefer internal
finance since funds can be raised without sending adverse signals. This to give
an option to current shareholders to not disclosure info and control.
If external finance is
required, firms issue debt first and equity as a last resort. The equity option
will bring more control from outsiders and lead to decrease the return on
current shareholders.
The most profitable firms
borrow less not because they have lower target debt ratios but because they
don't need external finance.
Some of the implications that
pecking order theory might come up with are: Internal equity may be better than
external equity, financial slack is valuable and If external capital is
required, debt is better. (There is less
room for difference in opinions about what debt is worth).
“The
pecking order theory predicts a negative earnings-leverage Relationship, which
is consistent with the empirical evidence. Although certain implications of the
pecking order theory have not received empirical support, in an overall
comparison between the two theories, the pecking order model has received
support over the trade-off theory.” (p3 , Sudipto Sarkar , 2000)
Practical Implications on Capital Structure
In dealing
with capital structure managers should start with a perfect market scenario and
start to apply practical variables exists in their environment.
Above theories were build on a
perfect market scenario, in this part I will analysis the practical variables
that might impact my mixing decisions.
Capital structuring sends signals to the various
divisions/groups regarding directional improvements in managers’ activities. In
an ideal world, businesses would be totally independent upon each other, sot that
the capital allocation decision could be compared with standalone businesses of
a similar size and complexion. In the real world, unfortunately, rarely are
businesses totally independent.
Company managers can distribute incentives to select
business components, depending upon circumstances.
Certainly, the total company must decide upon the
proper level of capital. As my point of view this decision affect the
predictability of earnings, the market’s perception of rewarding risk taking
versus risk avoidance, and the cost of borrowing debt funds as compared with
equity. Also, regulators must be convinced of the adequacy of the capital
reserves.
Once a company has found a
workable approach to this global problem, the organization can emulate it for
other capital budgeting decisions.
Regulated firms have more stable cash flows and lower
expected costs of financial distress and thus have more debt.
Advertising and R&D often represent discretionary
future investment opportunities, which are more difficult than Tangible assets
for outsiders to value. The costs of financial distress are higher if a firm
has more of these types of investments. The tradeoff theory predicts a negative
relation between these factors and leverage.
Intangibles assets firms will have many lack physical
existence. As such, they can support debt claims in much the same way that
tangible assets can support debt claims. Creditors can use their rights over these
assets in a default.
Suppose Your
Company owns hotel where occupancy falls and firm goes bankrupt.
The debt Holder sells to new owner
which will lead to low bankruptcy costs and legal and court fess. Where the hotel
business affected by bankruptcy.
Where in the
other example your company owns an electronics company where stockholders my by
unwilling to provide more capital in financial distress, which is more serious
than the case of hotel business. If the company goes bankrupt, creditors would
have difficulty selling off assets where most of the assets are intangible like
experience and engineers. Other type of difficulties will be keep the firm
carrying on as the odds of engineers resign are more and assurances to customers
that firm will be at the same level of service is less.
Some assets like commercial real
estate can go through bankruptcy largely unharmed. But companies with
intangible assets that are integral part of firm as going concern suffer major
loss in bankruptcy.
In
pharmaceutical industries for example the debt – equity ratios are low because
of the high investment in research and development where it can’t be
reevaluated in case creditors need their money back.
Other
industries like service and human capital investment we found the debt – equity
ration is too low.
The capital allocation issue
involves in a critical manner the amount of risk that an insurance company
should undertake. Greater capital requirements will reduce the chances of a
negative event, but at the same time reduces the profitability of the
enterprise. Several approaches are possible. For example, we could compute the
amount of Value-at-Risk by setting a constraint on the quantiles of the
company’s profit/loss distribution.
Debt is risk for new products
in unknown industries.
With higher
debt you will have higher interest but higher tax shield in a tax environment
managers have to think about the debt opportunity In a Tax free environment
there is no advantages of dept.
A high
tax rate is consistently positively associated with higher leverage. Depreciation,
investment tax credits, and non-debt tax shields are all considered to be
alternative ways of protecting income from taxation.
A
higher marginal of tax rate increases the tax-shield benefit of debt. Non-debt
tax shields are a substitute for the interest deduction associated with debt.
Therefore, all other non-debt tax shield variables like net operating loss
carry forwards, depreciation expense, non-debt tax shield measure and
investment tax credits should be negatively related to leverage.
With higher debt,
you will increase the probability of the company been bankruptcy.
Corporate
bankruptcy occurs when stockholders exercise their valuable right or the firm
gets into financial troubles where stock holders can walk away. Then creditors
become the new stock holders
|
Debt holder
will try not to reach to this exercise. They will give managers a chance even
with negative NPV projects.
There are different Types of
bankruptcy costs: Direct costs and Indirect Costs.
A Direct cost of bankruptcy
will be in lawyers, accountings and auditors On a tax environment Loss of PV of
Tax Credits and On Sales and customers this will affect Future Service and
reliability.
There will be Large costs of
switching suppliers and Lost up-front relationships.
Indirect
cost of bankruptcy will be the costs will be also represented as loose or Cutback
in R&D, advertising expenses, Operating Costs and Higher Labour Costs.
In an
inflation environment where the cost of financing is higher, the debt is good
where the purchasing power of the currency is strong and later return the money
when it has lower purchasing power.
When the
firm has difficulty meeting its financial obligations or cannot meet its
obligations , this will lead to bankruptcy.
Investors may be concerned that
levered firm may fall into financial distress where the
Value of firm = Value if all
equity – financed + PV(Tax shield) – PV(Costs of financial distress)
The cost of financial distress
depends on probability of firm being bankruptcy and magnitude of costs
encountered if distress occurs.
COSTS OF FINANCIAL DISTRESS
REDUCE THE OPTIMAL DEBT RATIO
Raising
additional debts are generally quick and less cost as compared to raise equity
, But the debt/equity ratio decision is often guided by the possibility of
finding fast sources of financing to take advantages of investment opportunities.
Company’s
debt liabilities become increasingly important as time progresses. Long-term
debt rose early in the period but has been fairly stable after a while from the
company life cycle, the net effect of the various changes is that total
liabilities rose from assets to while common book equity had a correspondingly
large decline.
Average corporate cash flows
statements normalized by total assets by decades show fairly remarkable changes
in cash flows of the companies. Big drops are observed in both sales and in the
cost of goods sold. The selling, general and administrative expenses more than
doubled over the period. As a result, the average firm has negative operating income
by the end of the period.
Dividend paying firms are less risky. If that were
true, then under the tradeoff theory dividend-paying firms should use more
leverage. But that is not what we find. Perhaps dividend paying firms can avoid
paying transaction costs to underwriters involved in accessing the public
financial markets. If so, then under the tradeoff theory, dividend payers
should have less leverage. This is what is found.
Under the pecking-order theory, dividends are part of
the financing deficit. The greater are the dividends, the greater the financing
needs, all else equal. Since financing is by debt, the implication is that
dividend-paying firms should have greater leverage. This is contradicting with
realistic scenario.
In Debt
which is the funds you owe the banks, this will need disclosure of more info
and the more info managers give, it will decrease the firm’s competitive
advantage and managers’ control.
If interest rates increase, existing equity and
existing bonds will both drop in value. The effect of an increase in interest
rates would be greater for equity than for debt. Thus, equity falls more,
leaving the firm more highly levered. In a tradeoff model, it seems that equity
has become somewhat more expensive, and so there should be little or no
offsetting actions. Thus, it is predicted that an increase in interest rate
increases leverage.
Adding capital
to an existing business often indicates that the managers are expected to go
out and gain some top-line growth. Conversely, eliminating capital can be
construed as a sign that the activity should be shrunk.
Brining more
equity to the firm will distribute the control over new shareholders which will
make the managers’ mission harder where he have to deal with more people.
To avoid the managers’ behavior of building empires
and care less about equity holders so debt is useful since debt must be repaid
to avoid bankruptcy. Bankruptcy is costly for managers since they may be
displaced and thus lose their job benefits. The idea that debt decrease agency
conflicts between shareholders and managers.
Where managers will try to work
for the interest of bondholders not to maximize their own wealth.
Suppliers of debt are generally concerned about
capital preservation, it they focused increasingly on insuring their position
by lending firms with more tangible assets and more cash flows.
In
a monopoly environment banks will determines unrestricted interest rates and
amount of dept giving to companies, where in a competition environment rates
will be less with more competitive advantages for firms.
References
Brealey,R.A., Myers, S.C., 2003, ‘Does Debt Policy Matter’, Principles Of
Corporate Finance, Tata Mc-Graw Hill Publishing,New Delhi.
Harris, Raviv 1999 in ,‘Capital Structure Decisions’, Business
Finance, Mc-Graw Hill Australia, Australia.
R. Brealey, S. Myers and F. Allen, Corporate Finance, 8th
edition, Irwin/McGraw Hill.
Sudipto Sarkar, “THE TRADE-OFF MODEL WITH MEAN REVERTING
EARNINGS, THEORY AND EMPIRICAL TESTS”,
Southern Methodist
University, February 2000.
Peirson,G., Brown,R., Howard, P., 1997, ‘Capital Structure
Decisions’,Essentials Of Business Finance, Mc-Graw Hill Book Company Australia, Australia.
