Issues in Corporate Finance: Trade-off Theory - Assignment Example

Introduction The capital structure of firms is a crucial issue that can lead to failure or success. Through the years, concepts were developed to fully understand the value of subject. In boosting the capital, companies have resorted to use their capacity to acquire debt. This power has either catapulted firms to success or further punctured companies to failure. Indeed, debts boost the capital of firms and improve financial flexibility. That, however, is realised using mechanisms that promote efficient capital structure. Firms have to be responsible in determining the debt to be acquired and the likely source of the borrowing. Most important, companies have to understand the value of trading-off aspects of capital because such practise results to better performance. The Theoretical Concept The trade-off theory of capital structure maintains the positive relationship between earnings and leverage. Empirical evidences, however, argue that such observation is fallible (Sarkar and Zapatero, 2003). Despite the contradicting outcomes, trade-off has considered as valuable mechanism in gauging corporate revenues. In most instances, the trade-off theory has consistently predicted information related to debt structure. The theory suggests that weak firms are more inclined to finance exclusively with bank debts. Apparently, weak firms tend to ignore other debt sources in particular public debts. Another important idea posited by the theory is that the optimal debt structure seen among strong firms pertains to combinations of bank and market debt. Basically, strong firms have become adept in successfully managing both bank and market debts. It has to be noted that the nature of both debts are differently perceived. Strong firms have the capacity to acquire different forms of debt instruments because of their financial scope. In uncertain markets, the strategy of using varied debt mechanisms allow strong firms to be more flexible in handling risks. According to Brealey and Meyers (2000), the trade-off theory pushes for value maximisation. Also, the theory presupposes static capital structure. Moreover, the theory contends that capital structures are influenced by market imperfections. On the other hand, the theory fails to consider capital market signals and concerns entailing proprietary information. Furthermore, critics claim that the theory is ill-equipped to justify relevant practises. The concept developed by Modigliani and Miller (1958) revolves on the market imperfections that eventually affect capital structures. Indeed, market imperfections occur in several forms. The most prominent observed among firms include taxes, market distresses, and agency costs. For most firms, the challenge is to create an optimal capital structure when these market imperfections emerge. The theory assumes that after a certain firm establishes the optimal combination of financial resources all succeeding financing is raised in the same proportion of debt and equity financing. This, however, is expected to vary in the method of reporting and practising. Among publicly trading companies, Houston and James (1996) observed that there is an insignificant use of market debt. The percentage of non-market debt among listed companies is greater in value as evident in the majority of firms preferring non-market debt. In addition, the listed firms that use market debts show that non-market debts still occupy the most shares on the overall debt. Johnson (1997) pointed out that the long-term debt structure suggests better use of market debts. Among the users of market debt, more than half of the total long-term debt is considered as market issued. Trade-off has usually been used to determine financing decisions. Traditionally, firms either maintain a target capital structure or follow the hierarchy of financing. Pinegar and Wilbritch (1989) conducted a survey on firms belonging to the Fortune 500 on their financing preference. Based on the results, majority of the firms listed in Fortune 500 have been using target capital structure to determine financing decisions. The trade-off model also suggests that firms with high profits tend to have high debt ratio (Sunder and Myers, 1999). The positive returns provided to the stockholders are associated more to leverage increasing circumstances. This contradicts to the earlier claims that target capital structure is not the primary basis for making financing decisions (Megginson, 1997). It is important to note that the market imperfection in this sense relates with the events that lead to higher profits. As the profit continues to expand, firms become more oriented with the required instruments to accurately make financing decisions and reach optimal capital structures. In predicting the optimal capital structure, the trade-off theory can be used to create other models. Ju (2001) considered using a trade-off theory derived model considering tax shields and bankruptcy cost. The model suggests that the decision of capital structures is based on the objective of maximising the total value of the levered company. In this model, tax gains and bankruptcy cost were traded-off. This was designed to determine the discrepancies in the effects of market imperfections to the capital structure. Subsequently, such information will lead to better view of optimal capital structure. Listed companies are usually provided with tax shields on debt. The trade-off assumes that taxes are existent even in debts. Interest tax subsidy, accordingly, needs to be boosted by generating more taxable income. Moreover, the value interest tax shield is reduced as firms continue to borrow. It is, therefore, beneficial to use the interest tax shield because it provides moderate tax advantage to debt. Aside from the taxes on debt, there are other aspects that can help firms in gaining optimal capital structure. The cost of bankruptcy occurs when the pressures of impending bankruptcy necessitates sale of assets. The loss is realised only after the assets have been liquidated. It has to be noted that the value lost when defaults occur are relevant to firms. Also, cost of financial distress also stirs the determination of capital structures. Such is precedent to circumstances related to loss of key stakeholders, the tendency of the returns of investments to be lower than expectations, and the opportunity cost gained in dealing with the situation (Passov, 2003). Holistically, the trade-off theory pictures a situation that shows the optimal capital structure is a trade-off between the tax benefits of debt and the increase in cost of financial distress concerned with the debt. Using a mathematical formula, the optimal capital structure of the firm is equals to the aggregate of operating cash flow and gains from interest tax shield less cost of financial distress. For the firms to reach the optimal capital structures, the operating cash flows and the interest tax shield have to be increased. In contrasts, firms have to ensure that the cost of financial distress related to the debt is reduced. Firms need debts to support the financing of their activities. Normally, the debts expand the capital structure of firms. This situation is not necessarily highlighting an optimum capital structure. The trade-off theory mentions that debt has to be slowed to improve the capital structure. The debt has to be maximised which means that it has to be translated into a viable source of cash inflows and avoids the cost of financial distress. Debt Benefits Jensen (1986) stressed that reducing the agency cost of the free cash flow is performed by the acquisition of debt. Indeed, debt is an instrument that allows financial flexibility and allows better decisions in financing. In discussing this view, it is imperative first to describe agency costs and its pertaining attributes. Theoretically, the agency cost pertains to the expense incurred by firms associated to problems such as divergent management-shareholder objectives and information asymmetry. These are viewed as the most logical instances that cause agency costs. In most firms, the CEO acts as the agent and the shareholders serve as the principal. Information asymmetry in this instance relates to gap of knowledge that both parties have. Indeed, there tendencies when the principal has more information compared with the agent. At times, problems between the two parties erupt and agency cost will normally increase. Debts are usually subject to shareholder approval before acquisition. On the other hand, there are tendencies indicating that the agent will hide the true purpose of the debt and eventually become a secret to the principal. Ross and Westerfield (2005) cited that when firms obtain debt, conflict will emerge between the stockholders and bondholders. In this scenario, the stockholders are perceived as the party on the losing end. To compensate for this imminent loss, the stock holders will impose agency cost on firms. These strategies come in the form of taking large risks, incentive towards underinvestment, and milking the property. Moreover, free cash flow calculates a company's cash flow remaining after all expenditures needed to maintain or expand the business have been settled. It signifies the net cash produced by a firm during a given period on behalf of stakeholders. Free cash flow is often calculated as operating cash flow minus capital expenditures (Shrieves and Wachowicz, 2000). In addition, free cash flow is significant because it represents the cash that is available for distribution to the company's stakeholders. Some investors favour using free cash flow instead of net income to measure a company's financial performance, because free cash flow is more difficult to influence than net income. Assuming that a company acquires debt, there are tendencies for the free cash flow to reduce its agency cost. It was previously mentioned that the stakeholders will eliminate the agency cost imposed once the dividends provided are sufficient. In acquiring debt, the free cash flow will be boosted in terms of the amount. Since capital expenditure remained constant, providing additional financial resources will enhance the dividends to be distributed to the stakeholders. This will eventually result to greater satisfaction and the stakeholders will be inclined to remove their imposed agency cost. It was mentioned earlier that the trade-off theory promotes reduction of financial distress and improving cash flow and tax shields. The debt has to perform beyond expectation and continue to resist interest tax. Likewise, the company needs to invest the debt in highly profitable ventures. Proper use of the debt will boost cash inflow attributed from the operations and will decease the likeliness of the debt to be underinvested. Railway Operator Establishing the capital structure of railway operators entails an analysis on the nature of the business. Availing debts is crucial for the company to ensure that its operations are consistently maintained. Logically, the first subject that comes to mind is the process in which the loans are obtained. It has to be noted that operating railways is not as highly profitable as other forms of businesses. This reality suggests that the cash flow will be predictable and routinely ascertained. Railway operations depend highly on ticket sales and cargo transportations. These observations need to be the primary concern of the company. It will better for the company to extensively devote its effort of acquiring market debt. Unlike bank debts, public debts allow the company with advantageous options that will fit its capacity to pay. Since investing on railway entails years before target returns are realised, market debts will be highly preferable. Using the trade-off theory, the company has to use its tax shield provided by the government. Usually, railways, as vital mean means of transportation are given incentives such as tax shield on interest incurred through debts. To fuel the free cash flow, the company has to determine the debt value ratio which will serve as the basis for acquiring the debt. One important consideration that has to be noted is that the assets of railway firms are vast. Hence, the company needs at least 15% of the value of the assets to improve its performance. Such amount is adequate to improve the operating cash flow because of enhanced quality of services. Most important, the cost of investment will be eventually covered by the debt. Soccer Team One of the dilemmas that a soccer team faces is the decision of building its own stadium. In doing so, the team needs a huge amount of debt for such to occur. Because stadiums have to be built as the team develops, it is important that debt services be acquired in the fastest method. For a soccer team, debt through banks appears to be the best option. First, bank transactions are speedy given that all requirements are satisfied. Second, banks can offer the amount needed by the soccer team to finance its plans of building a stadium. Market debts, however, are also possible alternative although in limited extents. The soccer team has the capacity to increase its cash flow. Basically, tickets are usually sold out even before matches are held. Aside from the tickets, merchandises sold by the team are valuable in the cash flow. In addition, the products and amenities in the stadium are also regularly purchased by the fans. These are expected to generate more dividends to stakeholders considering that the cost of investment remain constant. Increasing the free cash flow means that the soccer team needs to acquire debt and start on building a stadium that will house more fans. Given the quick inflow of cash from operations, the soccer team is capable of acquiring huge loans. It is advisable for a soccer team to obtain debt value ratio at around 40% of its assets. This will allow the soccer team to build the stadium faster than expected. Time is an important element that has to be considered. Definitely, there are possibilities of underinvestment once the soccer team fails to complete the stadium in the period when the team is winning championships. Conclusion Despite the criticisms, the trade-off theory has been influencing the capital structure of most firms. As the theory suggests, companies have to ensure robust inflow of cash and extensive use of interest tax shield. Using these tools, the company will decrease the tendency to acquire financial distress. For most firms, the cost caused by financial distress leads to situations worse than bankruptcy. It was also suggested that focus on the free cash flows will improve the capital structure. In this method, it was emphasised that lowering the agency cost will provide more benefits to stakeholders given the normal inflow of cash. Indeed, the capital structure of firms varies according to the nature of their operations and priorities. Whether is bank debt or market debt, it appears that the management of the capital structure is provided with more importance. References Brealey, R. and Meyers, S. (2000). Principles of Corporate Finance. Boston: McGraw-Hill Publishers. Houston, J. and James, C. (1996). Journal of Finance. "Bank information monopolies and the mix private and public debt claims." Jensen, M. (1986). American Economic Review. "Agency cost and free cash flow, corporate finance and takeovers." Johnson, S. (1997). Journal of Financial and Quantitative Analysis. "An empirical analysis of the determinants of corporate debt ownership structure." Ju, N. (2001). Dynamic Optimal Capital Structure and Maturity Structure. Maryland: University of Maryland. Megginson, W. (1997). Corporate Finance Theory. Reading, MA: Addison- Wesley-Longman, Inc. Modigliani, F. and Miller, M. (1958). American Economic Review. "The cost of capital, corporation finance, and the theory of investment." Passov, R. (2003). Harvard Business Review. "How much cash does your company need" Pinegar, L. and Wilbritch. L. (1989). Financial Management. "What managers think of capital structure theory: A survey." Ross, S. and Westerfield, R. (2005). Corporate Finance 7th Edition. New York: McGraw-Hill Publishers. Sarkar, S. and Zapatero, F. (2003). The Economic Journal. "The trade-off model with mean reverting earnings: Theory and empirical tests." Shrieves, R. and Wachowicz, J. (2000). Free Cash Flow, Economic Value Added, and Net Present Value: A Reconciliation of Variation of Discounted Cash Flow Valuation. Knoxville, TN: University of Tennessee. Sunder, L. and Myers, S. (1999). Journal of Financial Economics. "Testing static trade-off against pecking order model of capital structures." Appendix A Capital Structure of Listed Companies Trade-off Maximisation Component Driver Driver Operating Cash Flow Improved Revenues Better Fiscal Management Reduction of Costs Lagging Sales Misappropriation of Funds Inefficient Operations Interest Tax Shield Government Policies Low Rates of Debts Uncertain Economy Inflation Financial Distress Good Investments Organization Robustness Bankruptcy Disinvestment Jensen Model Operating Cash Flow - Agency Cost = Stakeholder Benefits Operating Cash Flow - Agency Cost = Stakeholder Benefits Proposed Capital Structure of Selected Organisations Company Debt Value Ratio Bank Debt Market Debt Railway Operator 15% 20% 80% Soccer Team 40% 65% 35% Read More