Capital Structure Evaluation of Sample Firms - Case Study Example

Capital Structure Evaluation of Sample Firms January 2009 Contents Sl No Page No Executive Summary .. 3 2. Capital Structure .... 4 Introduction ... 4 Capital Structure Models 6 Recent Developments on Capital Structure Models . 8 Analysis of firms .. 9 Conclusion ... 17 3. Appendix . 4. Bibliography ... 23 Section-I Executive Summary This report studies the different classical Capital Structure Models, and also evaluates the recent works in this area. The report shortlists five firms (public limited companies-PLCs) from four different industry segments, and analyses their capital structure and profitability. Finally, the report attempts to understand how far the different models and theories affect the real life capital structure of these firms. Section-II Capital Structure Introduction: A firm needs to deliver increasing returns every year to meet the return expectations of its investors, which can be ensured only by consistent growth in its revenue and profit. Such sustainable growth requires increasing investment in long term assets, which in turn needs to be financed by long term funds. The two conventional long term sources of fund are debt and equity. The proportion of such debt and equity determines the capital structure of the firm. There are benefits and shortcomings of both the funding options. While debt funds are considered to be less costly owing to the interest tax shield that they provide, equity funds are considered to be more expensive owing to its inherent risk profile. Though debt funds reduce an organization's weighted average cost of capital (WACC), such funding increases the risk profile of the organization owing to long term commitments secured by asset collaterals, which could seriously increase the bankruptcy risk of the organization during an economic downturn. The modern thinking on capital structure is primarily based on the seminal work done by Franco Modigliani and Merton Miller. The Modigliani-Miller theorem (1958) states that in an ideal world, the value of a firm is independent of its capital structure. When a firm increases its gearing ratio, the overall risk to the equity holders increase thus increasing the cost of equity, thereby having no net effect on the value of the firm. One important aspect of this theorem is that it ignores the bankruptcy and transaction costs, and assumes information is freely available to all firms. The optimum leveraging point of an organization is, therefore, always a source of debate, and has been subject of various continuously evolving theories and models. Some of these recent theories and classical models are examined and validated by analyzing the capital structures of five organizations (PLCs) from four different industry sectors. The firms chosen are as below. Table 1-1 Company Name Industry Sector TESCO Food manufacturing and products BP Oil, gas and energy Exxon Mobil Oil, gas and energy BHP Billiton Metals and mining British Energy Utilities TESCO is a giant in the food manufacturing sector with an annual turnover of 47.3 billion. TESCO was founded in 1919 in the UK, and has since grown to set up footprints across the world in the Asia, Europe, and the US. It is one of the leading food retailers of the world, and has diversified into petrol retailing. BP is primarily in the business of oil exploration and refining, and operates out of several countries. Its other businesses include alternative energy, and shipping. It has an annual turnover of $361 billion. Exxon Mobil is also in the business of oil exploration/ production, gas, and power. Its downstream business includes oil refining, and marketing of fuel products and lubricating oil. Its annual turnover is $390 billion. BHP Billiton is the world's largest diversified natural resources company with businesses including alumina, aluminum, copper, energy, coal, iron ore, nickel, manganese, oil and gas and uranium, as well as gold, zinc, lead, silver and diamonds. It employs approximately 41,000 employees, and operates across 25 countries. Its annual turnover exceeds $59 billion. British Energy is in the business of power generation, and is leading power producer in the UK. It is currently a part of EDF SA, and operates eight nuclear power plants, and one thermal power plant. Its annual turnover is 2.8 billion. These firms were chosen as adequate information was available about these firms in the public domain. Capital structure models: Trade-off Model: The traditional capital structure model is the "trade-off" model, wherein the risks and costs of the two funding options are evaluated by an organization to arrive at the "target" mix; thereafter the organization continually adjusts its capital structure to maintain this optimum gearing during funding of all its future investments. Bankruptcy costs as well as adjustment costs and deviation (from the "target" capital structure) costs are usually considered in this model. Pecking-order Model: The "Pecking-order" model maintains that organizations do not have a "target" mix, and raise funds preferentially from various sources in order of efforts required to raise funds, i.e., internal financing is the first option for managers, additional debt financing comes next, and finally managers raise additional equity finds when all the other sources of funding are exhausted. This model captures the cost of information asymmetries between better informed managers and less informed investors. Agency Hypothesis: Various agency costs can affect the capital structure decisions of an organization. High levels of debt and information asymmetries can result in divergent goals for managers and investors. For example, a high debt ratio could provide incentive to managers to invest in low NPV investments. Recent Developments on Capital Structure Model: This report studies several recent theories developed in the area on capital structure of firms, and evaluates those theories based on the data available from the sample firms chosen above. Ju et al. (2004) maintain that "trade-off" model performs reasonably well in the real world in predicting capital structures of firms. Against widely divergent views, the researchers deduce that the optimum debt to total capital ratio is 15.29% using a dynamic capital structure model. In fact, they maintain that within an optimal gearing ratio range of 11.0% to 20.3%, the change in a typical firm's value is only 0.5%. It is argued that a deviation of 10 percentage points from the "target" capital structure can be allowed before the organization attempts to recast its capital structure to optimize the transaction costs. According to the analysis of the researchers, most firms are over leveraged, which is in contrast to the other studies done since Modigliani-Miller. Gaud et al. (2006) contend that capital structure of firms depend on various other factors which are not explained by conventional models alone. They highlight that agency costs and timing issues impact the capital structure, and the gearing ratio is only subject to an upper barrier; while firms refuse to exceed a maximum debt level and prefer to repay debt or issue equity, there is no conclusive evidence about a lower boundary on the debt level. The study also finds that profitable firms issue debt to limit expropriation. Internal financing, wherever available, is preferred over external financing, but firms limit future excess of slack because it is a source of conflict. Profitable firms also prefer to increase dividends rather than decrease their debt level. It is also found that wealth transfers from shareholders to debt holders limit equity issues. Empirical evidence shows that managers attempt to time the market; they tend to issue equity when the market prices are high. They also contend that debt does not constitute a suitable form of financing for firms with value-enhancing investment projects. Instead, such firms issue equity. Hovakimian et al. (2003) argue that high market-to-book firms have good growth opportunities and, therefore, low target debt ratios. The probability of an equity issue increases while the probability of a debt issue declines with increase in market-to-book. On the other hand, while high stock returns are associated with higher probability of equity issuance, the probability of debt issuance is not affected by stock returns. They conclude that the importance of stock returns in studies of corporate financing choices is unrelated to target leverage, and is likely to be due to pecking order-market timing behavior. Their study indicates that probability of debt versus equity issuance increases with the firm's profitability. Furthermore, because unprofitable firms tend to be overlevered, they issue equity rather than debt. On the flip side, the propensity to issue debt when the firm is underlevered because of high profitability is neutralized by the firm's preference for and availability of internally generated funds. To summarize, the researcher's agree that firms do have target capital structures. At the same time, they have a preference for internal financing and also attempt to time the market by selling new equity when the share price is relatively high, which interferes with the firm's target debt ratio. Lewellen (2006) investigates the effects of managers' compensation on the firms' financing decisions. The certainty equivalent of the managers' compensation (especially option compensation when in-the-money) reduces with increase in the firm's leverage. More often, the managers do not prefer such riskiness, and tend to underlever their firms to maximize their own payouts. Korajczyk and Levy (2002) examines the effect on macroeconomic conditions on capital structure of firms. They conclude that macroeconomic conditions are significant for issue choice for unconstrained firms but less so for constrained firms. Unconstrained firms seem to time their issue choice to coincide with periods of favorable macroeconomic conditions, while constrained firms do not. Analysis of firms: This report then sets out to examine the various models, theories and hypothesis as described in the section above. In particular, this report attempts to test the following theories. Test if the firms follow the trade-off model. Test if the firms follow the pecking order model. Test whether firms maintain the "ideal" debt leverage of 15.29% as per Ju et al. Also evaluate if the firms maintain the optimal gearing ratio range of 11.0% to 20.3%. Test whether managers attempt to time their issues. Test if upper and lower limits to gearing ratio exist. Test if profitable firms issue debt to limit expropriation. Test if profitable firms prefer to increase dividends rather than decrease their debt level. Test whether high market-to-book firms have low target debt ratios. Test if high stock returns are associated with higher probability of equity issuance. Test if the probability of debt issuance is not affected by stock returns. Test if there is any effect of profitability on the target leverage. Test if managers' compensation has an effect on the firms' financing decisions. The debt to total fund gearing ratio of the sampled firms are given in table 1-2 below. Table 1-2 Debt/ Total Fund Year Tesco BP Exxon Mobil BHP Billiton British Energy 2008 33% 15% 19% 8% 2007 28% 14% 7% 26% 16% 2006 28% 11% 7% 29% 21% 2005 7% It is evident that Exxon Mobil follows a trade-off model, and clearly has a "target" leverage ratio. It was noticed from the balance sheet of its annual report that the firm mobilized $12 million during the period 2005-07, but the entire funding was mobilized without significantly affecting its target leverage ratio. Similar pattern is evident in the case of BP as well, which curiously is in the same industry segment as Exxon Mobil. Perhaps the agency costs viz., capital restructuring costs would have resulted in BP not following the target leverage ratio closely. The variance in leverage ratio is significantly higher in the other firms, which seem to have different drivers for capital structuring. All the firms in this sample set (except TESCO) have gearing ratio within the optimum 11.0-20.3% range postulated by Ju at al. TESCO is overleveraged, which is what Ju et al. predict in their study. Both lower and upper bands for firms' gearing ratio do seem to exist. However, the current dataset is too small to draw any conclusive evidence. The sample firms used a substantial part of their internal accrual for financing their asset building activities. In fact, British Energy retained all its earnings during 2006-07 to finance its investments. The summary of the firms' dividend payout ratio is given in table 1-3 below. The rest of the investments of the firms were financed by taking on additional debt. Table 1-3 Dividend Payout Ratio Year Tesco BP Exxon Mobil BHP Billiton British Energy 2008 28% 50% 20% 42% 2007 29% 39% 19% 17% 0% 2006 31% 36% 20% 20% 0% 2005 21% None of the firms issued additional equity during this period with the sole exception of British Energy who converted some warrants to equity. No new equity funding was taken up by any of the firms. This funding pattern exhibits the existence of a pecking order preference by the firms. Because no new fund was mobilized using new issue proceeds, the preference of managers regarding timing of their issues could not be tested. All the firms in the sample set are profitable (see table 1-4 below), and all of them seem to have preference for debt in funding their assets. However, the level of profitability seems to have a loose correlation with the target debt level. Firms with low profitability (e.g., TESCO) seem to have a higher affinity towards debt. Other high profitability firms do not seem to exhibit any distinguishable pattern. Table 1-4 Profit Margin Year Tesco BP Exxon Mobil BHP Billiton British Energy 2008 5% 6% 27% 12% 2007 4% 7% 10% 28% 16% 2006 4% 8% 11% 27% 17% 2005 10% Most of the firms (exceptions being BHP Billiton and British Energy) increased their debt position. British Energy and BHP Billiton actually paid off their debts using the retained earnings (see table 1-5 below), which is contrary to the predictions of Gaud et al. The preference for debt does not seem to have any relationship with the equity returns. Table 1-5 Incremental Debt Year Tesco (in '000) BP (in $'000) Exxon Mobil (in $'000) BHP Billiton (in $'000) British Energy (in '000) 2008 1,826 89 (1,546) (61) 2007 404 4,565 1,219 780 (57) 2006 - - 356 - - 2005 - The market to book ratio of the sample firms are given in table 1-6 below. Table 1-6 Market to Book Ratio Year Tesco BP Exxon BHP Billiton British Energy 2008 13 5 17 21 2007 17 6 12 31 9 2006 21 5 11 23 9 2005 11 Comparing the data in the above table with the table 1-1, there does not seem to be any correlation between the market to book and the target debt ratio of the firms. Noticeable correlation was not observed between the options held by the directors of the sample firms and their preference (or lack or preference) for debt capital. For example, directors of TESCO held 13.7 million options most of which is currently "in the money". However, contrary to the proposed theory of Lewellen, TESCO's preference for debt capital seems to the highest. Such preference could be the effect of the particular industry, but no noticeable pattern emerged by studying the options information. Conclusion: In conclusion, most firms seem to be following the trade-off model; albeit some of them seem to follow it more meticulously than the others. Majority of the firms also seem to conform to the pecking order preference for funds. In fact, some of the firms used the internal accruals to pay off existing debt. By and large, less profitable firms seemed to exhibit a distinct preference for debt capital. There did not appear evidence any effect of market-book ratio, or managers' compensation on the capital structure of the sample firms. Issue timing aspect of the capital structure could not be studied from the behaviour of the firms during the evaluation period. Section-III Appendix Share price data for the sample firms Section-IV Bibliography Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48 (3): 261-297. Ju, N.; Parrino, R.; Poteshman, A.; Weisbach, M. (2004). "Horses and Rabbits Trade-Off Theory and Optimal Capital structure". Journal of Financial and Quantitative Analysis, 40 (2), 259-281. Gaud, P.; Hoesli, M.; Bender, A. (2006). "Debt-Equity choice in Europe ". International Review of Financial Analysis, 16 (2007) 201-222. Lewellen, K. (2006). "Financing decisions when managers are risk averse", Journal of Financial Economics, 82, 551-589. Hovakimian, A.; Hovakimian, G.; Tehranian, H. (2004). "Determinants of target capital structure: the case of dual debt and equity issues", Journal of Financial Economics, 71, 517-540. Korajczyk, R.A.; Levy, A. (2003). "Capital structure choice: macroeconomic conditions and financial constraints", Journal of Financial Economics, 68 (1), 75-109. Wikipedia 2009, "Capital Structure", [Online] Available at: http://en.wikipedia.org/wiki/Capital_structure. London Stock Exchange, "The Annual Reports Service", [Online] Available at: http://londonstockexchange.ar.wilink.com/mkt_code=GOOGUK0053. TESCO 2008, [Online] Available at: http://www.tescoplc.com. BP 2009, [Online] Available at: http://www.bp.com. Exxon Mobil, [Online] Available at: http://www.exxonmobil.com. BHP Billiton, [Online] Available at: http://www.bhpbilliton.com. British Energy 2009, [Online] Available at: http:///www.british-energy.com. Yahoo Finance 2009, "Quotes & Info", [Online] Available at: http://finance.yahoo.com/charts Read More