Capital Structure - Assignment Example

Capital Structure Every business starts up its operations with a particular level of funding behind it. In order to perform various operations of business right from the formation stage till the bankruptcy, the company needs finance in order to back its assets (Berk and DeMarzo, 2010). Assets are obtained by capital providers with different sort of financing. Mainly, two broader forms of financing exist. 1) Equity 2) Debt Equity Equity is that type of financing in which the owners of the business provide capital to the business and they are entitled to the amount of profits that the business generates for them after meeting with all the expenses including interest expenses and tax expenses (Brigham and Ehrhardt, 2008). In company structure, owners are referred to as the shareholders or stockholders and they are entitled for the amount of dividend recommended by the board of directors of that particular company which is the appropriation of the amount of net profit after interest and tax expenditure. Debt Debt is another form of financing to the business in which debt holders provide the finance in terms of loan (Brigham and Ehrhardt, 2008). They want their principal to be repaid to them on the expiry of the term of loan. They are entitled to the specific amount of interest which the business must pay to them. Interest payments are normally computed as applying a certain interest rate to the amount of loan that they provide. These debt holders are not entitled to any amount of profit (Brigham and Ehrhardt, 2008). In case of bankruptcy, these debt holders are preferred over the owners in terms of receipts obtained after disposal of the assets. In company terms, the amount of loan is termed as debt, and loan providers are called as debt holders. Capital Structure Capital Structure is the term which is used to refer the capital mix of financing of the company. In simpler words, capital structure depicts the proportion of equity and debt involved in the financing of the company (Baker and Martin, 2011). It describes whether the company is financed by either equity or debt or a combination of both. However, the example of any company fully financed by debt is subject to extreme rarity. In financial terms, debt to equity ratio represents the capital structure of the company (Baker and Martin, 2011). Debt to Equity Ratio = Total Debt / Total Equity Financial Risk Financial Risk along with Business Risk constitutes the overall risk of the company (Roshan, 2009). Typically, a company is exposed to more financial risk when it starts taking more and more amount of debt in its capital structure. As the company increases the amount of debt, it increases the payments of interest; as a result, lesser amount of net profit becomes available for the owners. With the increase in financial risk, the company becomes more prone towards financial bankruptcy. In order to avoid such situations which lead a company towards financial bankruptcy, the company directors must ensure that the company must conform to the most optimal capital structure in such a manner that it should assists in running the operations of the business smoothly as well as avoid the chances of getting liquidated. Financial risk basically evolves with the increase in the level of “gearing” or “leverage”. As mentioned above, both terms mean the inclusion of debt in the capital structure of the company. As the company becomes more risky, geared or levered, the amount of net profits available to the stockholders starts to shrink (Roshan, 2009). From the example given below, a better idea on the effects of increase in the level of gearing would become clear. Suppose that a company has assets amounting to $1,000,000. There are two possibilities whether the company is fully financed through equity, in such a case the equity would amount to $1,000,000 or the company may inject debt amounting to $500,000 at 5% interest rate in the capital structure, in such a case, the equity would become $500,00 and debt would take the amount of around $500,000. Case I assumes that company is utilizing equity only whereas Case II assumes that company is utilizing both debt and equity in backing its assets.   Case I Case II   Equity Equity + Debt Expected EBIT 100,000 100,000 Interest - 25,000 EBT 100,000 75,000 Taxes (40%) 40,000 30,000 Net Income 60,000 45,000 Expected ROE 6.00% 9.00% 60,000/1,000,000*100 = 6% 45,000/500,000*100 = 9% From the above mentioned table, it is quite prominent that in case of gearing, the expected return on equity to the stockholders is increased from 6% to 9%. Since the company is increasing its debt, making itself more risky, therefore, the stockholders would also increase the required ROE in such case. The MM Model Capital Structure was not taken seriously by the companies until a more scientific study of Franco Modigliani and Merton Miller published in 1958. In this study, Modigliani and Miller (MM) presented the capital structure in a more coherent and analytical way along with different consequences of capital structures over the value of the firm. Assumptions of MM Model MM model assumes the following points in respect of optimal capital structure. 1) Standard Deviation of EBIT is the measure of the business risk. If the standard deviation of different firms is of the same degree, all those firms would be constituted under same and homogenous class of business risk. 2) The earnings and risk exposure of a firm are estimated by all the stockholders in the same manner with homogenous expectations. 3) Perfect market assumption prevails such that there is no brokerage cost and the borrowing rate for the individuals and the companies would be the same. 4) The debt that firm uses of the individuals and the companies is free of risk. Risk free rate would be applied in determining the interest rate. 5) Perpetual cash flows are assumed such that investors can expect the constant cash flows in the years to come for the company since it does not undergo any growth strategy. Propositions of MM Model Tax-free Economy MM postulates the following propositions assuming tax free economy. Proposition 1 The value of a firm can be computed by capitalizing its expected operating income (EBIT) at constant weighted average cost of capital which is cost of equity: VG = VU = EBIT = EBIT WACC ksU Proposition 2 The cost of a geared firm is equal to the cost of un-geared firm and the amount of risk premium. Risk premium can be referred as the differential amount of cost of equity and cost of debt. ksG = ksU + Risk Premium = ksU + (ksU – kd)/(D/S) Where, VG = Value of Geared firm VU = Value of Un-geared firm ksG = Cost of equity of geared firm ksU = Cost of equity of un-geared firm kd = Cost of Debt The above propositions present that the capital structure does not matter in the valuation of firm as the basis for valuation of growth for both geared and un-geared companies are the earnings before interest and taxes. Since there are no taxes applicable in the economy, therefore, that portion of earnings would be left over for appropriation for the stockholders and debt holders. In this way, “capital structure is absolutely irrelevant in determining value of a firm” (Miller, 2012). Taxable Economy MM postulated the following proposition in a tax based economy. Proposition 1 The value of a geared firm can be computed by adding the value of un-geared firm with value of tax savings. VG = VU + DT VU = EBIT (1-T) ksU Proposition 2 The cost of a geared firm is equal to the cost of un-geared firm and the amount of risk premium. Risk premium can be referred as the differential amount of cost of equity and cost of debt and the corporate tax. ksG = ksU+ Risk Premium = ksU + (1 – T)(ksU – kd)/(D/S) However, in a tax world, the value of a geared firm is more than that of un-geared firm by that amount of tax savings. Hence, if the firm keeps increasing the amount of debt in its capital structure, ultimately its value would be increased because of increased tax savings. Reduction of Agency Cost through the use of Debt When a company starts including more debt in its capital structure, this leads towards problem of agency relationship between the stockholders and the debt holders (Berk and DeMarzo, 2010). Stockholders want to issue more debt by securitizing the previously old secured assets of the firm whereas the debt holders requires that whenever a new debt is raised it should be charged on new assets of the firm. By keep charging on the same asset, the risk of debt holders increases and they want to avoid this situation. For this purpose, the bond holders set more restrictive covenants for the use of those charged assets and the cost of monitoring those covenants would have to be charged by the stockholders. There comes the conflict between the stockholders and the bond holders. So, if a company wants to reduce its agency costs, it should try to maintain an optimal capital structure which fulfils the requirements of the company in running its operations as well as assist in reducing the agency costs. References Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. 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Wright, Bill M., 2009. Modigliani Miller Theory - Is Capital Structure Irrelevant? Available through < http://www.finance30.com/forum/topics/modigliani-miller-theory-is?commentId=1987892%3AComment%3A662962> [Accessed 4 February 2012] Read More