Capital Funding Structure a Marine Company - Essay Example

CAPITAL FUNDING STRUCTURE –A MARINE COMPANY Introduction A UK-listed high-growth company that wants to expand operations or take advantage of a promising investment opportunity is faced with the challenge of how to obtaining additional financing. The chief financial officer of the company also has to make a choice whether the security be in the form of debt or equity, or a combination of both. The most important consideration is what form of capital structure would be most helpful in maximizing the firms value. This paper seeks to address the issue of what constitutes an optimal capital structure, and what modes of financing can be used. Theories underpinning determination of capital structure. a. The Modigliani-Miller Models In 1958, Franco Modigliani and Merton Miller, two prominent financial economists, constructed a theory of capital structure (usually referred to as the MM) that is widely considered as the most influential financial theory up to this time. Basically, the MM theory assumes perfect capital market conditions where all relevant information is readily available, where there are no transaction costs, and where borrowing and lending rates are the same for all investors. The theory likewise assumes that there are no income taxes, that operating income is constant over time -- i.e., there is no growth -- and that all earnings are paid out as dividends. Under the above conditions, the theory concludes that capital structure does not matter because the cost of capital remains the same regardless of capital structure for the following reasons: 1. The cost of debt is always lower than that of equity because equity is more risky. 2. As the debt/equity ratio increases, the cost of equity capital will rise because stockholders will incur more risk. 3. The risk-free interest is constant. 4. The weighted cost of capital remains the same because the increased cost of equity capital is exactly offset by the increased weight of the lower-cost debt in the capital structure. In 1963, Modigliani and Miller modified their original work by including corporate taxes. With such taxes, leverage would increase the firms value because interest on debt is a tax-deductible expense and more income accrues to the investors. Consequently, the value of the firm increases. The cost of debt is the after-tax yield (1-tax). This lower cost of debt, combined with the existing cost of equity, will result in a lower weighted average cost of capital the greater the leverage. The benefits of debt financing derive from solely from the tax deductibility of interest payments. This observation would lead one to conclude logically that the company should use more leverage to the extent that all financing will be done through debt. In reality, however, companies do no such thing. While historically the debt/asset ratios have risen overall, companies maintain capital structures that are stable with a some combination of debt and equity at some in-between point. (See Brealey & Myers; Brigham & Gapenski; Keat & ). Much later, Merton Miller extended the theory by including personal taxes. Personal taxes in the modified model would reduce -- but not eliminate -- the benefits of debt financing. Because the introduction of personal taxes lowers the income to investors, they reduce the value of the firm, other things being equal. b. The Traditional View The traditional view is that some gearing (leverage) is beneficial and leveraging (increasing debt relative to equity) increases the return on equity. The expected return on the portfolio of a firms securities is determined by the weighted average of capital. In considering a project, the company computes for the net present value of all cash flows from the project when it does not differ from the firms business risk. When leverage lowers the the WACC, the value of the firm accordingly increases. This runs counter to the MM proposition that the increased return on equity in a leveraged firm reflects the increased risk of the added debt; and that shareholders will consequently demand a higher required rate of return, so that the value of the firm or its stock is not increased. Further, the traditional view holds that the required rate or return does not increase; that the WACC declines at first as leverage increases, then rises; and that there is an optimal debt/equity ratio where the cost of capital is lowest. The traditional view assumes that investors are insensitive to the increase in risk created by additional debt. Equity holders would criticize management for not taking advantage of gearing up to a certain point, provided that the after-tax cost of debt would be less than the desired return on equity. The following illustrates the debt/asset ratio plotted horizontally, and cost of capital is plotted on the vertical axis: Fig. 1 (Source: Keat & Mathis, Financial Management) Note that with the WACC at the minimum, the market value of the firm is at its maximum. When the debt/asset ratio is increased further, the market value of the firm may start to decline. It would seem that companies have an idea of what its optimum capital structure might be. Because a desirable capital structure can vary or change with time, it may be appropriate to identify an optimal range rather than an optimal point in the graph. Fig. 2 (Source: Keat & Mathis, Financial Management) c. The Trade-Off theory Under the trade-off model the marginal cost and benefits are balanced against one another, yielding an optimal capital structure that would lie somewhere between zero and 100 percent debt. An optimal debt ratio is one which reflects a trade-off between tax shields and the costs of financial distress. Financial distress can arise because, as the company continues to increase its leverage (debt/equity) ratio, debt carries progressively increasing risk. Borrowing to take advantage of the tax deductibility of interest may cause lenders to require higher interest rates until such point that the firm can no longer borrow. The increase in borrowing costs will begin to offset the advantages of the tax deductibility of interest. Companies with substantial tangible assets usually can borrow with less risk than high-growth technological companies whose asset values largely consist of intangibles. The prospect of financial distress looms when the firm can no longer meet its obligations to the creditors. Financial distress can lead to a loss in value of the business, affecting both its stocks and bonds. The value of the firm may be described as the sum of the its value under the assumption of fully equity-financed and the present value of the tax shield, less the present value of the costs of financial distress (See Brealey and Myers 1999). The costs of financial distress include the bankruptcy costs (costs involved in creditors being allowed to take over the assets of the company and controlling the business), the cost of operating the business under the cloud of bankruptcy, and agency costs (which shall be described later in this paper). Bankruptcy costs are nominally large for small firms but less in relation to large firms. There are other financial distress costs such as the difficulty of hiring able employees and getting suppliers to cooperate, as well as the market price drop at the expense of present investors. Agency costs occur when a non-bankrupt financially troubled firm creates conflicts of interest between shareholders and creditors. Here shareholders can "play games” that can hurt lenders, such as investing in risky negative-NPV projects, refusing to contribute additional equity, issuing more and riskier debt, among others. Lenders counter these shareholder tactics by using strict conditions in debt contracts, thereby reducing shareholder flexibility and adding to the costs. d. The pecking Order Theory It has been a practice of many companies to have a preferred order of financing choices. This is done by using internal equity or retained earnings (and depreciation) first, followed by debt, and finally , as a final resort, new common stock. Brigham and Gapenski (1993) also call this the asymmetric information theory, which assumes that managers have better information than investors. At the same time, the theory posits that managers tend to maintain a financial slack, or flexibility of means in order to meet future financing needs. Funds may be held in the form of marketable securities and spare borrowing capacity, such as a bank overdraft line or leasing arrangements (Cornell & Shapiro 1993). A survey of capital structure practices. In order to discover the practices of companies and industries with regard to their policies on capital structure, in 1995 the Compustat Industrial Data Tape (cited in Brigham and Gapenski) compiled the results of survey of the financial leverage of U.S. companies both across industries and among firms within each industry. Table 1 below reproduces part of the results thereof. Table 1 Capital Structure Percentages Four Industries Ranked by Common Equity Ratio Industry Common equity Preferred stock Total debt Long-term Debt Short-term Debt Return on equity Drugs 74.40% 0.00% 25.60% 18.70% 6.9 26.40% Electronics 68.40 .00 31.60 24.50 7.10 11.70 Retailing 53.60 1.00 45.40 39.40 6.00 16.20 Utilities 46.90 5.30 47.80 43.80 4.00 5.60 Composite (average of all industries) 37.70 1.50 60.80 38.70 22.10 11.70 Note that drugs and electronic companies did not use much debt owing mainly to substantial expenditures in research Utilities have average debt ratios, while retailing normally use debt for inventory purposes, and its long-term debt as a ratio to common equity is less than 1. The authors state that the variations among firms within the industry are also wide, citing the drug industry where Bristol-Myers Squibb had 11 percent debt while Warner-Lambert had 46 percent. They conclude that "factors unique to individual firms, including managerial attitudes, play an important role in setting target capital structures." (Brigham and Gapenski 1993). Data such as the above do not make for definitive judgments about industry-specific characteristics of capital structures. Absent any recent data, it is believed that the same variability would tend to persist over time among these companies. A survey of UK listed companies A survey of the financing decisions of UK listed companies was conducted several years ago by Beattie et al (2006). The survey attempted to determine whether these companies used the trade-off theory or the pecking order theory when they made financing decisions. The findings of the study can be summarised as follows. While it was assumed that pecking order theory and trade off theory are competing descriptors of company practice, or mutually exclusive, it was found that 32 percent of the respondents followed both theories while 22 percent followed neither. Sixty percent followed a hierarchy (pecking order) while 50 percent followed a target capital structure (trade off). Consonant with the findings of an earlier research (Norton), the conclusion pointed to the fact that “firms seem to use an eclectic approach when considering financing alternatives.” Our comment is that CFOs are practical people and use whatever approach works best, whether or not they are aware of these two theories. A good metaphor might be mixed martial art fighters who may opt to use jujitsu, Thai boxing, or judo, depending on what particular skill is called for at the moment. Although capital structure theories contributed to the way capital structure decisions were made, the answers given by finance directors of the UK listed companies were not fully consistent with either of the main theories mentioned above. The researchers attributed this finding to bounded rationality, as propounded by Herbert Simon: The capital structure decision is complex and multi-dimensional. In addition, some responses reflect organizational inertia. There are complex group processes that still have to be grasped. Specific company examples In order to understand whether companies have a pattern in their capital structure decisions, we have analyzed the capital structure of two UK listed companies, one in the marine industry and another in the airline industry. To inquire about their specific choice as between pecking order theory or trade-off theory entails interviewing the financial officers of these companies, which is beyond the scope of this study. The debt pattern however give us some inkling about their targeting of capital structures through five years of Balance Sheet data. We do not suggest that the results be used to make a generalization about company practice of UK listed companies as a whole. Table 2 1. Jet Blue Airways Item (million British Pounds 2008 2007 2006 2005 2004 Total Liabilities 4,762. 4,562 3,891 2,981 2,043 Total Long Term Debt 2,883 2,588 2,626 2,103 1,396 Total Current Liabilities 1,081 1,256 854 676 488 Total Equity 1,261. 1,036 952 911 754 LTD/Equity (capitalisation) ratio 2.29 2.5 2.76 2.31 1.85 Debt/Equity ratio 3.78 4.4 4.09 3.27 2.71 The capital structure of Jet Blue Airways is characterized by a consistently high gearing within a certain range throughout the last 5 years of operations. Both the capitalization and gearing ratios shows a targeted range. Because the company is stable, the high gearing may be justified; however, it would surprise no one if the shareholders would demand a higher required return on their investments. (Source: Moneycentral.msn.com) 2. Raymarine PLC Table 3 Item (million British Pounds 2008 2007 2006 2005 2004 Total Liabilities 143.18 99.35 70.98 69.26 82.99 Total Long Term Debt 105.09 65.29 38.37 40.08 52.53 Total Current Liabilities 34.31 26.61 29.76 25.11 26.11 Total Equity 21.64 26.61 22.62 17.96 10.51 LTD/Equity (capitalization) ratio 5.00 2.40 1.65 2.35 5.00 Debt/Equity ratio 6.5 3.67 3.1 3.8 7.5 (Source: Moneycentral.msn.com) Raymarine is highly geared throughout the last 5 years but the variability in the debt-to-total capitalization ratio is quite remarkable. In any industry, the ratio of 1 is probably the limit with 1 Pound of long-term debt per Pound of equity. The range found in its Balance Sheets ranges from 1.65 in 2006 to 5.00 in 2004 and 2008 for the capitalization ratio and between 3.1 and 7.5 for the gearing ratio. The company, it seems, does not have a target capital structure to speak of. Raising investment funds for a high-growth marine company A high-growth company in any industry would normally find it difficult to obtain financing for its project as compared to companies that are stable, mature, and showing stable cash flows in the past several years. While companies of the latter category have tangible assets, high-growth companies usually have a large proportion of their assets as intangibles. Thus in case it encounters cash-flow problems or nearing financial distress, the intangibles are the first to go, and the remaining tangible assets may not be adequate to meet the demands of its creditors. This explains why finding financing sources can pose quite a challenge to a growth company, even in an environment where high gearing is allowed. A growth company is going to face serious financial difficulties if it is not equipped with substantial amount of equity and cash right from the start, even if doing so involves deep discounts. This is because later on it has little credibility to tap the debt market, obtain bank financing, or float new shares in the market. With enough financial strength from the very beginning, it is able to obtain the commitment of its suppliers and other stakeholders in order to develop a relationship that can assure its continued existence and ability to take advantage of investment/growth opportunities. In the event that the company has to obtain more financing or capital it has to alternative sources. One of these is venture capital. Venture capitalists provide equity, but in return they demand control and expect higher returns. They also require that management display commitment by putting up their own funds, by receiving modest compensation, and by linking incentives to results. Venture capitalists usually contribute capital in the form of convertible preferred stock because it gives them prior claim on the companys assets and at the same it gives them the opportunity to become shareholders when the company performs well. To limit further their exposure to business risk, venture capitalists do not provide all the funds at once but by stages – that is, after certain milestones are achieved. In this way, they would be able to cut their losses when things do not pan out, but they would be able to provide more capital when things go as planned. Banks are another alternative. Banks can customize loans in line with the unique financial requirements of the high-growth company , and the loan terms can be flexible and negotiable. The monitoring of the progress of the investment, the consultation and advice, and the rescheduling of the loan repayments are certainly convenient to the management of a firm which is subject from time to time to the vagaries of the business environment. A third alternative financing source is private placement. Compared to bank loans, which can charge relatively high interest rates, and venture capitalists who impose burdensome conditions and controls, private placements can be cheaper and the terms of the placement can be negotiated. The negotiation can involve disclosure of important information to provide the investors assurance that their investment will yield good returns. In some cases, restrictive covenants that they want included can discourage the firms management from further pursuing this option. The regular bond and equity markets are alternatives that are difficult for the growth company to tap. In line with the pecking order theory, retained earnings should be the primary sources of funds, followed by debt, and then equity. As retained earnings are nil or minimal, the debt and equity options have to be resorted to. Faced with credibility problems and the fact that a large part of its assets are intangibles, thereby making the firm vulnerable to financial distress when it encounters cash problems, the management has to be creative in finding ways to obtain finance. The use of bank loans, venture capital, and private placements are worthy alternatives to explore. BIBLIOGRAPHY Beattie, V. and Goodacre, A. and Thomson, S.J. (2006) Corporate financing decisions: UK survey evidence. Journal of Business Finance and Accounting 33(9-10):pp. 1402-1434. Viewed December 10, 2009 at http://eprints.gla.ac.uk/3336/ Brealey, RA, Myers, SC & Marcus, AJ, 1995, Fundamentals of Corporate Finance, McGraw-Hill, Boston, Mass Brigham EF & Gapenski, LC 1996, Intermediate financial management, 5th edn., The Dryden Press, Orlando, FL raymarine references Cornell, B & Shapiro, AC 1993 "Financing corporate growth" in Chew Jr, The new corporate finance, Prentice Hall, New York. Jet Blue Airways Annual Balance Sheets. Viewed December 13, 2009 Data from: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=JBLU&lstStatement=Balance&stmtView=Ann Keat, PG & Mathis, FJ 2003, Financial Management. Simon & Schuster, New York McLaney, E 2000, Business Finance: Theory and Practice, 6th edn. . Myers, S 1993 The search for optimal capital structure" in Chew Jr, The new corporate finance, Prentice Hall, New York. Parrino, R & Kidwell, D 2000, Fundamentals of Corporate Finance Raymarine plc: financial statements. Viewed December 14, 2009 at http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=RYMRF&lstStatement=Balance&stmtView=Ann Ross, SA, Westerfield, RW & Jordan, BD 2000, Fundamentals of Corporate Finance, 9th edn. Watson, D & Head, A, 2000, Corporate Finance. Read More