How Can a Capital Structure Has more Contribution to the Values of the Firm - Research Paper Example

Corporate Finance Table of Contents Corporate Finance 1 Table of Contents 1 Introduction 2 Strategy Vs Financial Structure 2 Capital Structure: Theories in Practice 3 Modigliani Miller Propositions 4 Trade-off Theory 5 Pecking Order Theory 6 Financial Distress: Liquidity Position 7 Cost incurred in Bankruptcy 8 Changing Capital Structure: Changing Beta 9 Conclusion 10 Reference 13 Bibliography 14 Introduction Strategy is important, but financial structure is more important for a firm. This project is the collection of viewpoints which how can a capital structure has more contribution to the values of the firm. The report starts with a discussion on strategy, human resources and financial structure; how each of them is contributing to shape up the success of a firm. This has been presented with a viewpoint that the financial structure is most important among these. Later on the theories of capital structure would be revisited; in some stages the importance theory would be validated against that of business strategy of the firm. Wrong financials can put a firm into distress and sometimes can push down to bankruptcy. There are a number of costs attached to each of the phases. A discussion is there to put forward the fact that strong liquidity position can pull back a organisation form the event of financial distress. Capital structure impacts the risk return of the firm. This has been discussed later on. At conclusion, the report is based on the fact that financials are the important most for a firm rather than its business strategy; although both complement each other to the successful completion of the business activities. Strategy Vs Financial Structure No doubt, strategy is quite important for a firm’s operational success. People are the key resources of an organisation to attain success. When a strategy goes on a toss or a company hires some wrong people, it is going to be an upsetting situation for that company. The organisation is supposed to loose a number of customer base and hence make loss of significant amount of business and market shares. The question is what if the strategy is in place, the people are qualified enough to carry on the operations, but the finance structure is in strangled situation; whether the firm would be able to make success or would be in a better situation. Wrong strategy can surely put a firm in troubled situation, but erroneous capital structure can put the firm in more worsened position. If the capital structure does not matter much for the firm, then the financial managers would not have worried so much about it. Financing decisions should have been assigned to the underlings. If debt policy were of no such importance, then the debt ratios would have varied arbitrarily from company to company, industry to another industry. However, quite different pictures have been seen in real life, where most of the airlines, utilities, banks mostly are heavily debt oriented, while the pharmaceutical companies or the advertising agencies mostly rely on the equity capital. These patterns are quite importance to the fact that capital structure is important for a firm. If any firm does not have proper capital structure, it is very much probable for the organisation to fall in distress. Debt burden can hit a firm so badly that a proper placed strategy would not be able to abstain the firm to fall in bankruptcy; and in such a situation the loss incurred would be much more than that would be incurred in case of wrong strategy or having wrong personnel on board. Capital Structure: Theories in Practice Access to the funds is a key issue in every organisation and developing a capital structure policy can let one to choose from the avenues those are open to finance the operations. Some financial managers choose the easiest avenue possible, which is all equity financing. While some other financial managers end up taking a lot of financial debt on its accounting book. The skill lies in finding out the perfect combination of debt and equity in the capital structure. Modigliani Miller Propositions There have been few theories to decide on the capital structure of a firm. Modigliani Miller (MM) proposition is one of those. As per the MM proposition, in a perfect market any combination of financing would be as good as the other one. This means that the firm value is indifferent of its choice of capital structure. The main disadvantage of this proposition is that this holds true in a perfect capital market without any taxation or transportation cost. In reality it is not possible to have a capital market with no taxation. A well qualified and experienced employee base with a well developed corporate strategy can make a serious contribution to the operating profit of the company; but the net profit margin would decline as the tax amount is quite high. A high tax amount would lower the net profit margin, despite of an increase in the cash inflow from the operating activities. MM’s proposition I says that the value of the firm would not depend upon the fact how it is distributed between the debt and equity parts, which means that a dollar decrease in the debt amount would only result in a dollar decrease in the equity portion (Brealey, Myers & Allen, 2007). In the whole scenario one important slice, missing, was that of the government’s. The pre-tax profit margin does not contain the government taxation part, but surely the after tax profit margin is quite dependent on the tax amount. So to increase the net profit margin the company needs to increase its debt level, which would reduce the tax bill of the government. As per MM proposition 2, the expected rate of return for a levered firm on common stock is positively proportionate with the debt equity ratio. In this case the debt equity ratio needs to be expressed in market values. Expected Return on Assets = (Proportion of debt * Expected Return on debt) + (Proportion of Equity * Expected Return on Equity) (Brealey, Myers & Allen, 2007) This expected return on investment is also known as cost of capital, the minimal return the shareholders would expect from the firm. MM proposition I says that shareholders’ wealth is independent of the financial leverage, the company has on its accounting books. The second proposition says that the expected return of the stock investors increases as an increase in debt equity ratio. Any hike in return is counterbalanced by the risk attached to it. If a firm is intending to invest in a project which is in the same domain as the firm operates in, the cost of capital would be same as that of the firm (Donaldson & Fox, 1961). Trade-off Theory Financial managers often treat the firm’s debt equity decision as a trade off between the tax shield and the cost of distress. As per the trade off theories there can be a wide variation in the debt proportion in capital for firm to firm. Most of the companies with productive and safe tangible assets and high profit tend to have high debt ratios. The reason is they have enough profit to shield it from the tax deductions. While on the other side the unprofitable companies with risky assets mostly rely on the equity funding. For an instance a company has made a large profit by the help of their well qualified and experienced human resources and a well developed tactical implementations. The company prefers to have no debt on its portfolio and so is financed with all equity. Another company with the same gross profit level, but has moderate debt on its portfolio. No matter whatever strategy the firms have adopted, the net profit margin of the former would be much lesser than that of the later one; and one of the important characteristics of a successful organisation is it high profitability. This profitability can be put in trouble if the capital structure is not structured properly, in alignment with the financial and operational needs of the firm. As per this theory high profits could be used to service the debt and higher income to protect and hence that would result in higher target debt ratio (Brealey, Myers & Allen, 2007). Although the trade off theory encourages the firms to have more debt on its accounting book, still it is the responsibility of the firms to make a debt policy on its own in accordance with the risk profile they are willing to take on their portfolios. Another factor, needs to be taken into care is that the firm has a stable and steady cash inflow, which can be used to pay off the debt in financial distress. In general it can be seen that the public organisations carry on major shifts in their capital structure just to have the advantages of tax shield on their asset values. Pecking Order Theory Another theory which keeps concern with the capital structure of a firm is that the pecking order theory. It is based on a fact that managers know the firm more than its investors. They have much better idea about the prospects, risks and values of the company. This creates an information asymmetry among the information both the parties have. Asymmetric information impacts the choice among internal and external financing and moreover among debt and equity securities. This asymmetry leads to the pecking order theory. As per this theory, managers prefer to finance their fund with their internal funding which have reinvested primarily (Young & O’Byrne, 2001). The next preference would go to the debt financing; managers would like to fetch capital through new issuance of debt. Issuance of new equity is the last way out, mangers would like to explore. Managers take this avenue whenever they run out of debt capacity (Brealey, Myers & Allen, 2007). Having more debt on the accounting book would increase the probability of financial distress. At that time the debt investors would be cautious enough to put any further money into the company, which would compel the managers to go for new issuance of equity (Bierman, 2003). On the other sometimes even the managers would like to go for equity when they find the debt level of the company has increased to a risky affair. Mostly high tech, growth oriented companies prefer to have low debt on their portfolio as their assets mostly consist of intangible assets with high distress cost. That is why these types of firms go for conservative financing with the issuance of new equity. It is better to have an example how information asymmetry can led a manager to go for debt financing. A firm and another one have issued shares for equity financing. A company whose share is supposed to be worth 120 is selling at 100 and another one, whose stock is worth some 80, is also selling at a price of 100. This happens because of information asymmetry between the managers and the investors. Such unevenness in stock prices made the financial mangers prefer debt financing over equity financing. Financial Distress: Liquidity Position It is quite apparent that if a firm does not take care of its capital structure, it is very much probable for it to fall into financial distress. However not every firm, which falls in distress goes bankrupt. As long as the company has enough cash to pay off the interest on its debt, it can be able to push back bankruptcy for many years. In due time, the firm would recover, pay off all its debt and may escape bankruptcy in whole. Surely a firm, which is in financial distress means that most of the stakeholders would be very much negative about the firm and may willing to sign off from their respective positions. For an example suppliers may not be willing to invest to service their requirements and may demand cash for their products. Definitely financial distress might be quite costly for the firm; but from there only the financial status of the firm can get it back on the track. For an instance, the strategy of a business went wrong and the company has fallen in financial distress. It is not quite apparent that the company would go bankrupt. If the company has enough liquidity to pay off the current liabilities of the company, it may be possible for the firm to postpone its bankruptcy (Brealey, Myers & Allen, 2007). On the other hand a company, with weak financials but a strong strategy has fallen in distress. Despite of having a better strategy at place, the company would have more probability to go bankrupt as it does not have enough cash to pay off the current debts. A company can not go through the implementation process of its operating strategies until the financials of the company does not support the same. For an instance, a company might have a very attractive opportunity to go with, although the opportunity may be quite risky. A finance manager might not like to go with the same as the firm already have much debt on its portfolio. For the well being of an organisation, the strategy needs to be in accordance with the capital structure of the firm. Cost incurred in Bankruptcy When a company goes bankrupt, a number of direct an indirect costs are involved with the same. Apart from the legal fees, company has to pay off its debt holders first and then to the stockholders with the remaining capital they have. Managing a bankrupt firm is not an easy task to carry on. Consent is required from the bankruptcy court to carry on many usual business activities like selling off the assets or investing in new equipments. Theses all would take time and effort. Sometimes the creditors may become adverse to theses decisions, as they prefer their cash to be paid off rather than recovery of the company, itself. Although the indirect costs can not be measured in physical terms, still it will not be wrong to say that the bankruptcy cost amount huge for a company, mainly a large one. Costs of distress can vary depending upon the categories of assets. Assets like good commercial real estates can help a company to bypass the bankruptcy. The losses can be more for the intangible assets like human resources, technology and brand image. This is a reason why the pharmaceutical industry prefers to have low debt ratio on its accounting book (Brealey, Myers & Allen, 2007). . Changing Capital Structure: Changing Beta The shareholders and bondholders both get a slice of the cash flow of the organisation and with a proportion for risk. Debt holders hold much lesser risk than the shareholders. The asset beta is equal to the weighted average of debt and equity betas. Asset Beta = Debt Beta * (Debt /Firm Value) + Equity Beta * (Equity/ Firm Value), (Brealey, Myers & Allen, 2007) Where Firm Value (V) = Debt + Equity After refinancing the debt and equity both would come more risky. Borrowing creates financial leverage. Financial leverage does not put any effect on the risk or on the return of the company’s assets, but it increases the risk attached to the common stock. In such a case the share investors are supposed to demand more return to compensate the risk, they are bearing in this company. Financial slack in Capital Structure A number of financial managers think that they would prefer to be at the top of the pecking order, rather being at the bottom of it. Financial managers have an idea that their shares may not be sold at the fair price; that is why they prefer to go for debt financing. Financial slack means that the company has enough cash, marketable securities and readily available financing avenues. If a company has much cash and cash like assets on its portfolio, investors are supposed to see that as less risk prone and so would like to invest in the respective company. Financial slack is more profitable to the growth oriented firms which have higher positive NPVs (Brealey, Myers & Allen, 2007). This is a reason why the growing firms prefer to have conservative approach towards the capital structure. In long run the company may be in need of capital; and in that situation financial slack can be beneficial for the company. However having a financial slack sometimes can be disadvantageous for the company. The financial managers pile up cash and then they invest excessive cash into ill advised projects or mature businesses. So it is up to the financial managers how they would like to use the financial slack in capital structure (Brealey, Myers & Allen, 2007). Conclusion Traditionally the primary goal of an organisation is to create value for the shareholders as they are supposed to have control over the organisation. As per the set of contracts theory, a firm can be viewed as a set of different contract claims. The shareholders have the residual claim on the assets and cash inflow of the company. This theory says that the managers must act in accordance with the interests of the shareholders of the respective firm. On the other hand the management could have a different goal sets (Aghion & Bolton, n.d.). They are more interested in the organisational survival and independence in their control. Corporate wealth is mostly related to the growth and sixe of the corporation. This can not termed as shareholders’ value. Corporate wealth is the wealth used for exploring the growth opportunities of a firm (Ross, Westerfield & Jaffe, 2005). Striking a balanced capital structure is quite needed for the firm to maximise its corporate value. A firm needs to carry on a competitive strategy to be ahead of its competitors. A well established strategy can increase the sales of a firm. A production and operation strategy can enable a firm to get enough economy of scale to decrease the cost of revenue. The employees in the firm can be much capable to carry on the task they are assigned to. This would surely reduce the model risk which can happen due to human error. In such a scenario, the productivity of the firm is supposed to increase to a certain level. No doubt, that these factors are very important for the growth and succession of a firm; but financial structure is important for the survival of the firm. Due to some wrong strategies or some other reasons a firm can plunged to financial distress; but still a firm can have the ability to get out of that situation and recover from the same. It would be only possible if the firm has enough liquidity to pay off the interest and debt, it has on its accounting book. In absence of a high leverage or low liquidity ratio, the probability for a firm to go bankrupt is quite high. The cost attached to the bankruptcy is a proof that absence of proper financial structure can hit much more badly than an inappropriate strategy. A firm’s capital structure also has an impact on the risk and return attached to the respective firm. Financial slack in a firm’s capital structure is quite necessary as that would leave enough space for the firm to avail readily available required capital. Investment must be done with cautious judgement so that the ultimate aim to increase the corporate wealth can be attained. Moreover, strategy and capital structure complement each other. Sometimes the firm’s strategy would depend upon the financial structure of an organisation; and sometime sit would be other way round. A perfect blend of strategy and capital structure would take a firm to excel in its operational and financial activities. Reference Aghion, P. & Bolton, P. No Date. The Financial Structure of the Firm And the problem of Control. [Pdf]. Available at: http://www0.gsb.columbia.edu/faculty/pbolton/PDFS/financia.pdf [Accessed on February 26, 2010]. Bierman, H. The capital structure decision. USA:Kluwer Academic Publishers, 2003. Brealey, R., Myers, S. & Allen, F. Principles of Corporate Finance. New York: McGraw Hill, 2007. Donaldson, G. & Fox, B. Corporate Debt Capacity. Washinton: Beard Books, 1961. Ross, S., Westerfield, R. & Jaffe, J. Corporate Finance. New York: McGraw Hill, 2005. Young, S. & O’Byrne. EVA and value based management. USA: McGraw-Hill, 2001. Bibliography Brav, A, Graham, J, Harvey, C and Michaely, R. ‘Payout policy in the 21st century’, Journal of Financial Economics, 2009. Brealey, R., Myers, S. and Marcus, A. Fundamentals of Corporate Finance. New York: McGraw-Hill/Irwin, 2009. Burrough, B. and Helyar, J. Barbarians at the Gate. London: Random House, 2004. Chew, D. (ed) The New Corporate Finance: Where Theory Meets Practice. New York: McGraw-Hill/Irwin. Growth, J. No Date. Capital Structure: A Strategy that Makes Sense. [Pdf]. Available at: http://www.qfinance.com/contentFiles/QF02/g26fs3i7/16/0/capital-structure-a-strategy-that-makes-sense.pdf [Accessed on February 26, 2010]. McLaney, E. Business Finance: Theory and Practice. Harlow: Pearson Education Ltd., 2009. Neale, B and McElroy, T (2004) Business Finance: A Value-Based Approach. Harlow: Pearson Education. Read More