Optimal Capital Structure - Coursework Example

INTRODUCTION TO CAPITAL STRUCTURE The corporations are large separate entities, the foundation of which is based on the way they are financed and supported. Capital structure intends to define the way the company has been financed, that is, how its assets have been bought: whether through equity, debt or hybrid security options or a combination of these options. Therefore, the capital structure is the way the liabilities of a company have been structured by the company. The capital structure of an organization can tell volumes regarding the financial stability of the organization for years to come. It is the way through which the organization finances the working of the organization, all the liabilities that are needed to be paid off sometime. Therefore, for analysts as well as prospective buyers, the capital structure of an organization bears immense importance. The essay is structured to introduce the term capital structure to the audience, through the eyes of prominent Franco Modigliani and Merton Miller, discussing the two propositions that were made. The discussion moves onto developing further methods to understand the capital structure and to analyze kind of structure works the best for the organization. CAPITAL STRUCTURE: The term capital structure has been defined with respect to the Modigliani-Miller Theorem, which was proposed by Franco Modigliani and Merton Miller. The theorem is an idea which propagates the capital structure thinking in the modern era, though it still ignores the countless new factors, which leaves the theorem with many flaws. This theorem proposes the fact that in a perfect market, with so many firms competing in the market with almost similar product offerings, the capital structure of the firm does not affect the overall value of the firm. It is irrelevant to study the way the firm has been financed, since it has no such effect. But since the market is not perfect, the theorem states that in the real world, the capital structure has a lot of meaning to it and should be studied. For instance, if there is a company which has $30 million finance which has been taken as debt, and $70 million finance which is equity supported, then it can be said that the firm is 30% debt financed and 70% equity financed. This will be the capital structure of the organization, and is a very vital piece of information for all the stakeholders, whether they are the creditors, the media, the general public, the employees, the management and the customers who do big business with the company. Usually, it is more important to focus on how much debt has been taken by the firm because that is more or less of a weak point faced by the firm, since it has to repay the debt that has been taken. Therefore, another term, the firms leverage, has been introduced for this aspect. In the example that has been given above, we can say that the firm has 30% leverage, since it has taken 30% debt in the total capital that it has raised. The above explanation of capital structure and the simple sources is actually an explanation which suits well to theory. In reality, the scenario is very complicated, and a real company has an array of options to choose from when they are thinking of sources to raise capital from. There are not just one or two, but multiple sources. Many ratios and metrics are there to calculate the capital structures viability for a particular firm. One of them is the gearing ratio, which tells about the amount of capital that the firm uses, which has come from outside sources, and not owned by the firm itself. The gearing ratio would become high when the firm has taken a short term loan from outside. MODIGLIANI AND MILLER The concept of dividend policy in finance has always been a controversial issue. The question of whether a firm should offer dividends and its consequences has many answers. The rightists to this answer believe that an increase in the dividend policy will end up increasing the stock value and in turn foster value creation for the company. On the other hand, the leftists to this proposition believe that an increase in the payout ratio to the shareholders is bound to decrease value. In the middle of this continuum lie the middle-of-the-road party which was founded by Modigliani and Miller; in 1961, they proved through a research paper that the dividend policy is irrelevant in a scenario neglecting taxes, transaction costs or other market imperfections. Proposition 1 According to the first proposition of M&M, there should be no impact on the actual value of the firm due to the kind of capital structure. This means that two firms who have the same business profile and same assets may have them financed in different ways and methods, but that doesn’t affect the overall value of the firm (Brealey, 2006, 448-449). According to the first proposition, the value of the firm is dependent on the kinds of assets that it owns regardless of the way they are financed (Brealey, 2006, 448-449). Proposition 2 In the second proposition, M&M state that there are three things on which the value of a firm is dependent. They are: 1) The required rate of return on the assets of the firm 2) Cost of the debt of the firm 3) The debt to equity ratio of the firm The above mentioned three things are what impact the value of the firm. According to M&M, as the debt increases, the stockholders start demanding more return as they will be the last ones to be satisfied in a liquidation position. If the debt to equity ratio increases, the return on equity will increase as well (Brealey, 2006, 455-456). WEIGHTED AVERAGE COST OF CAPITAL Weighted Average cost of capital shows the cost of investing in an organization. It incorporates in itself all the risks and returns associated with the organization. In order to incorporate the market risk, the market values are used, for the equity and the bonds, to calculate the WACC. For example, if in an organization, 50% is financed by debt and the other 50% is financed by equity; the stockholders are demanding a return of 10% whereas the bond holders want 20%. Therefore, the average return to satisfy all the investors should be: WACC= (0.5*0.10) + (0.5*0.20) WACC= 15% Here, the percentages of equity and debt from the total investment are multiplied with the demands of respective investors to find the weighted average (Ross, 2004, 328-329). CAPITAL ASSET PRICING MODEL The Capital Asset Pricing model is significantly used to value an asset’s worth. A company that has a portfolio of investments going on, its total risk will be the weighted average risks of all the investments it has made added together. Therefore, a well diversified portfolio of businesses/investments/assets will help an organization have a stable and low risk structure; this in turn will ensure a lower beta. Beta is a variable that measures the market risk associated with an organization. Usually, for an organization, there are two types of investors. The stockbrokers are those who invest in the stocks of the organization and the bond holders, who provide secured or unsecured loans to organizations. To understand the risk that both these kinds of investors face, we shall assume that there are no taxes being paid by the organization for now. The impact of increasing the leverage on both the stock holders and the bond holders is different (Ross, 2004, 295). To evaluate the beta of a firm, one should understand that the firm’s beta is actually the beta of the assets that the organization holds. The weighted average of all the firms associations and investments should be calculated. The formula to do this is to multiply the relative weight of the stocks in the total investment by the beta of the stock, and add it to the weighted beta of the bond. The expression of calculating the beta is important because it is not possible to find the beta of assets directly; one needs to know the beta of the stocks and the bonds from the market (Ross, 2004, 295-296). β of Assets = [(E/(E+B))*β of E] + [(B/(E+B))*β of B] When a firm is equity financed completely, the beta of that firm will be equal to that of the beta of the stocks; this firm will be called an unlevered firm. However, this will not be the case when there is some proportion of stock investment as well as bond investment. The above mentioned formula is for the levered firm; the firm which has stocks as well as bonds investments in it (Ross, 2004, 295-296). EFFECT OF CAPITAL STRUCTURE ON BETA Investors, while evaluating the firm, take into account the risks associated with the venture. Therefore, beta is an important variable that take into account the market risk associated as well. At the point of liquidation, the bond holders will be satisfied first, and then the residual will go to the stock holders. Therefore, the systematic risk of the stocks is higher than that systematic risk of the whole firm. In many situations, they may not be paid dividends even. In such a situation, the only gains they make are through the increase in the value of the stock. Therefore, when we observe the beta of the stocks, it not only incorporates the systematic risk of the firm’s operations, but it also the effects of corporate structure of the firm. The more debt the firm has, the more risky it is. As they organization will be tied to pay interest payments every year. However, the firm’s operations do not become risky; therefore the ultimate impact is on the beta of the stock only. When one wants to evaluate a project they should go for unlevered beta, and the WACC is the best way to do make that evaluation (Brealey, 2006, 457) THE TRADE OFF THEORY The tradeoff between the debt tax shield and the costs of financial distress has now allowed the companies to develop an optimizing leverage ratio. It identifies the target debt ratios that will help the company to achieve maximized firm value. In simple, the companies with a high number of tangible assets, high and definite income have high target debt ratios whereas the companies with weak and uncertain income and a low number of tangible assets will have lower targeted debt ratios. (Brealey, 2006, 490-491) This theory defines the value of the firm as: Value of all-equity-financed + PV (Tax Shields) – PV (Costs of Financial Distress)1 It states that the debt should be increases until the benefits of the debt offset the costs of the financing. In simple, the marginal benefit of the debt financing decreases as the amount of debt increases. At the same time, the marginal cost of the debt financing increases as the amount debt increases. Therefore, the company will decide the amount of the debt and the equity that will maximize the value of the firm. (Brealey, 2006, 490-491) The theory takes into consideration the bankruptcy costs and the non-bankruptcy costs of the company. The bankruptcy costs include the direct and the indirect costs such as court fees, management during the liquidation process and others. On the other hand, the non-bankruptcy costs relate to the credit risk, agency problems and high employee turnovers. These problems are particularly related to the management issues during the liquidation of the company. (Brealey, 2006, 497) The trade off theory explains the different capital structures between different firms within the industry. It also clarifies that a company with a strong positive profit has a high capacity for debt and a strong urge to capitalize on the capacity. (Brealey, 2006, 498) PECKING ORDER THEORY When it comes to the various theories that come under the capital structure financing of the firm, one other theory is the Pecking Order Theory. It was initiated proposed by Stewart Meyers and Nicolas Majluf in the year 1984. The theory is based on the concept of asymmetric information. This means that the managers inside the firm have more knowledge with respect to risk, value and future prospects of the company as compared to the investors and the public. This theory helps us choose between the external and the internal sources for the financing of the company in the profitable investments. This principle of least efforts has been replicated in the capital structure theory by stating that a firm will always try to use those sources of capital which will require its least efforts, that is, it would not be required to go through a long and daunting process in raising capital. When seen through such a perspective, it gets well known that the most gigantic and difficult task is to raise equity. (Brealey, 2006, 492-496) The most lucrative task that any firm would want to do in raising capital would be to finance everything from self money. The owners of the firm, when they do their initial meeting, decide on the amount of money or capital that they would put in the firm, which would be their own, and the risk would be their own too. Such money has the least effort, since all the owners have to do is use up their savings for the benefit of the firm. The next source of capital structure financing which requires more effort than putting ones own money but lesser effort than doing capital raising by equity is the raising of money through debt. When money is raised through debt, the ones who provide the firm with debt become the creditors of the firm, and they have to be returned their money in due time. The procedure is not that tedious, and firms would always opt for debt rather than equity at any given point in time. (Brealey, 2006, 492-496) The pecking order theory states that the internal sources are preferably used by the company. If these are not available, the company moves to the next option of debt and finally to the equity option if the debt option has been exhausted. This theory also tend to explain the fact that the profitable companies have low debt ratios which is in contradiction to the trade off theory. These profitable companies finance their projects from the internal sources as they have huge reserves. Therefore, they tend to rely less on the external financing and hence, have lower debt to equity ratio. (Brealey, 2006, 492-496) CAPITAL STRUCTURE RATIO ANALYSIS The financial leverage analysis with the help of the ratios assists in determining an optimal mix of debt and equity for the company. There are some capital structure ratios that allow for the analysis of the financial structure of the company. Debt-to-Equity Ratio Debt-to-Equity Ratio = Long term debts/ Shareholder’s Equity The ratio assists in determining the long term financial policies of the company and specifies the relative share of the external sources in comparison to the internal sources. A low ratio is good indicator for the creditors as the huge equity provided for the safety net for these creditors. At the same time, it indicates ineffectiveness of the management to use the debt capacity for the maximization of the shareholders’ wealth. A high ratio indicates the aggressiveness of the company and involves a high amount of interest payments. This shows that the company is highly exposed to the interest rate movements and will be affected. On the other hand, a low ratio indicates the conservativeness in the capital structure. (Keiso, 1316) The ratio is of immense importance to the creditors and shareholders and therefore, the company always tries to portray the ratio in the positive light. Capital Gearing Ratio Capital Gearing Ratio = Fixed Interest Bearing Securities/ Equity Shareholders’ Fund This ratio exemplifies the relationship between the fixed interest bearing securities issued by the company and the equity. The fixed securities include the bonds, share capital and debentures. It basically indicates the level of funding in the company’s operations by the owners and the creditors. (Keiso, 1316) Interest Coverage Ratio Interest Coverage Ratio = Income before Interest and Income Tax Expenses/ Interest Expenses The ratio signifies the ability of the company to pay off the interest payments as they become due. A low ratio indicates that the company is facing problems in paying off these payments. A ratio of 1 indicates that the company is not able to generate enough revenue to make the interest due payments. Therefore, this is an important ratio that indicates the ability and the credit worthiness of the company’s long run creditors. (Keiso, 1316) Financial Leverage Ratio Financial Leverage Ratio = Adjusted ROE/ Adjusted ROA It is considered to be one of the most efficient measures of the analysis of the capital structure as it takes the adjusted values into the calculations. An index greater than 1 signifies that the ROE exceeds the ROA and that the company is using the debt financing in a favorable tone. On the other hadn, an index of less than 1 indicates that ROE is less than ROA and that the company makes unfavorable use of the debt financing. RISK ANALYSIS The capital structure of any organization directly impacts the riskiness that the respective company faces. It refers to the possibility of losing something of value due to the unfavorable use of the debt. The style of the capital structure: conservative or aggressive determines the credit risk of the company. A company with a conservative capital structure profile will face less credit risk because the company has less debt, has less fixed commitments to answer and has a greater cushion for the lenders in the case of default in shape of equity. An extreme case of credit risk is the bankruptcy risk. If the company is unable to cater to the maturing interest and debt payments, it moves into a financial distress position. It finally approaches the bankruptcy position. (Brealey, 2006, 693-696) When a company has a high debt in its capital structure, it is susceptible to the fluctuating changes in the economy specifically related to the interest rates. Therefore, the earnings and the income of the company are more volatile and uncertain. Hence, it faces the business risk. (Brealey, 2006, 693-696) Therefore, the risk analysis indicate towards the optimal level of equity and debt financing that will help the company maximize the shareholder’s value as well as put the company in the investors bright zone. THE OPTIMAL STRUCTURE A capital structure that has low WACC maximizes the value of the stock but does not maximize the earnings per share. On the other hand, greater leverage will increase the earnings per share, however, increase the risk associated with the firm. The existence of an optimal capital structure is debatable. An optimal capital structure will be the one that involves some debt but which is not 100% financed by debt. Usually, it is not possible to find the optimal point therefore a range of optimal points is taken as a bench mark. Therefore, firms should strive to reach at a point that maximizes the earnings per share and minimizes the risks associated with the firm. This optimal structure may be at different points for different organizations, depending upon the risk factors etc. References Bierman, H. (2003) The capital structure decision. Springer. Brealey, R. A. Myers, S. C. Allen, F. (2006) Principles of Corporate Finance. McGraw-Hill Hamson, D. (1990) Capital structure: static trade off, pecking order or circumstances. Mitsui Life Financial Research Center, School of Business Administration, University of Michigan Myers, S. (2001) Capital structure. Ross, S., Westerfield, R., Jaffe, J. (2004) Corporate Finance. 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