The Need to Manage Capital Structure Effective In Maximizing the Wealth of Business - Dissertation Example

?Critically evaluate the need to manage capital structure effectively in maximizing the wealth of business organizations. Introduction A simple balance sheet sheds light upon the liability section which reflects the capital structure of an organization. An organization obtains its capital from both external and internal sources. However, the optimal capital structure is decisive upon a number of different factors. Thus, there is a possibility that two organizations in the same industry have completely different capital structures. Objectives of an Organization According to Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." (Aswath) According to Copeland & Weston: “The most important theme is that the objective of the firm is to maximize the wealth of its stockholders.” (Aswath) Thus, it has been very aptly defined that the main objective of an organization is to maximize the wealth of its shareholders and thus, capital structure is an important factor constituting towards this development. Objectives of Capital Structure Planning The importance of the capital structure planning can be summarized in the following diagram. Source: http://www.svtuition.org/2010/05/importance-of-capital-structure.html To reduce the overall risk of the organization The capital structure of an organization needs to be devised in such a manner that the overall risk is minimized. The acquisition of debt in the capital structure sets up an added liability of interest payments. Contrarily, equity financing means a rate of return in the form of dividends to be paid to the shareholders. Thus, debt raises the “risk” for the shareholders. Adjustment according to business environment The concept of “maneuverability” is applicable in this regards. This means that there is mobility of sources of funds which has been gained through maximizing the alternatives in the planned capital structure (Capital Structure Planning, 2010). Thus, according to the changing business environment the source of funds are flexible enough to be adapted. Idea Generation of New Sources of Funds All the organizations are in need of capital structure adjustments. Thus, they need to raise capital either through external or internal finance. Therefore, a risk lowering and a profit maximizing capital structure would help finance manager to raise capital easily and efficiently (Capital Structure Planning, 2010). Capital Budgeting Capital budgeting refers to investment in projects that pay a rate of return in the long-run. The asset acquired is evaluated by various techniques so as to reach the decision of whether or not to purchase them. This is of utmost importance in financial management and thus, the technique was used by General Motors to overcome their losses in 2002. There are five techniques to rank whether a project should be included in the capital budget or not. Source: http://assets.cambridge.org/97805218/17820/excerpt/9780521817820_excerpt.pdf Payback Period This technique is simple and shows the time frame for the investment’s net revenues to cover its costs. Discounted Payback Period This methodology also provides the time frame but the calculation procedure is different. The cash flows are discounted at the rate of the investment’s cost of capital to achieve the length of time that would cover the cost of investment. Net Present Value (NPV) Future values of the cash flows are discounted at the cost of capital to obtain the NPV of the cash flows (Brigham & Houston, 2003). The investment venture is than ranked according to the NPV of the cash flows. This technique makes the use of discounted cash flows and is quite advantageous. A positive NPV demonstrates that the investment not only covers the cost of investment but also earns a profit. Whereas, a 0 NPV means that cash flows generate an enough amount only to cover the cost of the capital. Internal Rate of Return (IRR) The IRR is the discount rate that forces the PV of an investment to equal the PV of its costs (Brigham & Houston, 2003). Therefore, the Cash flows are discounted using this IRR and the investment is ranked accordingly. If the IRR exceeds its cost of capital, the wealth of the shareholders increases. If the IRR is less than the cost of capital, than there is an extra burden posed on the shareholders. Modified Internal Rate of Return (MIRR) The concept of terminal value is used in this case. The terminal value is the sum of the future values of the cash inflows compounded at the firm’s cost of capital. The MIRR is the discount rate where the PV of an investment cost equalizes the PV of its terminal value (Brigham & Houston, 2003). This method is positively related to the NPV method as both yield the same decision. Target Capital Structure There is generally a trade-off between risk and return in Financial Management. More debt means that there is an increase in the risk of the shareholders. Contrarily, it also leads to high rates of return on equity. This has opposite implications as an increase in the risk lowers the prices of stocks; whereas, an expected higher rate of return increases them. Therefore, when deciding upon the capital structure of the organization, a balance between risk and return needs to be maintained (Brigham & Houston, 2003). Factors Influencing Capital Structure Decisions Business Risk This is the risk that a business inherits when it does not inculcate any debt into its capital structure. This is mainly due to the fact that the only risk is undivided and the bearers are the shareholders. Thus, business risk in case of all equity financing is quite high. The firm’s tax position Debt is useful in this case because it is tax-deductible which reduces the effective cost of debt. However, if the tax rate is very low than acquiring extra debt would not be an optimal choice. Financial Flexibility The target capital structure is highly influenced by the potential future need for funds and the consequences of funds shortage (Brigham & Houston, 2003). Thus, in times of financial difficulties, the organizations with a strong balance sheet succeed in gaining financing as debt and equity. Managerial Conservatism or Aggressiveness This is the case when the managers intend to boost profits and thus, rely more upon the debt financing in order to gain excessive profits. This does not modify the capital structure to an “optimal value maximizing” one. Critical Evaluation It has been mentioned in the beginning that the goal of all organizations is to maximize the wealth of its shareholders. However, the crucial matter is how this has to be achieved. The increase in the wealth of shareholders can be achieved through the increase in the market value of the shares of their stocks. Moreover, the capital gains of an organization can also add up to their capital. There are certain factors that organizations cannot control such as the tax rates and the market interest rates (Brigham & Houston, 2003). But there are some core factors that could be controlled and that actually lead to the maximization of the wealth of stock holders. 1. Capital Structure Policy An organization sets up an optimal level of capital structure and uses it as a target to achieve. However, the Weighted Average Cost of Capital can be calculated by making use of the targeted debt, common and preferred stocks (Brigham & Houston, 2003). It is implied that the capital structure that maximizes the stock price, minimizes the WACC. An increase in the debt ratio leads to an increase in risk which results in higher interest rates. Therefore, to tackle this, experts use forecasting techniques to measure the changes in current ratio, times-interest ratio and the EBITDA coverage ratio caused by the changes in debt ratio (Brigham & Houston, 2003).In order to achieve benefits in the face of high market value WACC should be reduced by manipulating all the weights. It is also noteworthy, that the change in debt/equity ratio has an effect on the cost of equity through the Hamada Equation. Thus, an increase in the ratio increases not only “risk and interest rate” but also “cost of equity.” If an organization is “leverage-free” than its ROE equals its ROIC. Operating leverage could also be controlled by the firms so as to increase the profits of shareholders. Thus, it can be said that the market value of the shares would rise if an optimal structure of debt and equity is applied. No debt has its inherent “business and financial risk” and leverage adds to “risk and higher interests.” Low-cost debt might be solution but when the debt starts increasing than again the feedback effects could be felt. 2. Dividend Policy Firm try to adopt the optimal dividend policy that strikes a balance between current dividends, future growth and maximizes the stock price of the firm (Brigham & Houston, 2003). The organizations usually make use of their retained earnings for the purpose of financing purposes rather than raising equity by issuing more common stocks. Moreover, dividend cuts are also least preferred since both common stock sales and dividend cuts causes the stock prices to lower down (Brigham & Houston, 2003).Moreover, issuing new common stocks have issuance and floating costs associated to them. Therefore, to maximize the benefits of organizations and shareholders, long-term investment prospects should be considered and the value of the stock prices should maintained by not issuing new stock or lowering the dividends. 3. Investment Policy The required rate of return on the firm’s outstanding stocks and bonds reflect the riskiness of an organization’s assets. Thus, investment in similar assets implies a similar rate of return. However, investment in other kinds of assets would alter the riskiness respectively. A high risk would lower the market value resulting negatively for the shareholders and vice versa. Conclusion Capital structure is indeed the back bone of the wealth of shareholders. Thus, the decision to issue new stocks, debt or finance through retained earnings, all affect the shareholders. The gearing ratios of an organization are of great concern. gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets). An organization with high gearing ratios is susceptible to downturns as the payment of interest rate is a necessary requirement. Contrarily, equity financing is an added cushion to an organization’s capital structure and a source of financial strength. However, equity alone is also not considered optimal. Therefore, the optimal capital structure can vary from organization to organization even in the same industry. Discuss the problems of agency theory and evaluate the role of effective financial management in addressing these problems. Agency problem is not a new concept. When the owners of an organization referred to as principals hire other individuals or agents to carry out the decision making, the agency problem arises (Brigham &Houston, 2003). The main agency relationships are between the managers and the share-holders and the managers and the debt-holders (Jensen, 1976). The root cause of the problem is that the profits and costs of the organizations do not completely accrue to the managers as they do not occupy the 100%v shares of the organization. Therefore they have a relaxed attitude. Not only this, but they also work for their own incentives rather than maximization of stockholders’ wealth. This is mainly due to the fact that the stock holders have to bear the costs for their perquisites (Shleifer & Vishny, 1997). The goal of the managers is to increase sales or the size of the organization so as to empower their own position (Brigham &Houston, 2003). There should be techniques applied so as to reward the managers to act in shareholders’ interest. 1. Managerial Compensation This technique needs to be implemented so as to reward the managers. These include fringe and other monetary benefits to the managers. Moreover, Performance Shares can be given to the managers on the basis of the market value of the shares of the organization (Brigham & Houston, 2003). This could add to the benefit as they would earn a greater share of ownership and hence act in the interest of the stock holders. In 1991 Coke granted one million shares to its CEO but on the compulsion that he would remain a Coke employee for the rest of his life (Brigham & Houston, 2003). 2. Threat of Take-overs If the organization is not producing results that are up to mark and the stock prices are on a declining trend too, than mergers or take-overs can take place even when they are not in agreement with the management. According to Michael Jensen, the maximization of the value is a scorecard and should refer to the long-term benefits of the organization. Moreover, he explains the enlightened stock holder theory and emphasizes that the stock holders should also focus upon the long-term trend. The working environment and agency problem needs to be tackled as he believes that no constituency could be left behind. He also explained the asymmetric information and the word “value” which must not be confused by “optimization”. Thus, nobody knows the perfect value but they want to maximize it by adopting better strategies. Effective Financial Management could be quite successful in dealing with these problems. For instance, the capital structure is an optimal solution to deal with this problem. For example a high risk project adds to the required rate of return on the firm’s debt. Thus, this problem needs to be dealt by proper capital budgeting. Moreover, WACC needs to be calculated to see the capital structure trend. Conclusively, EPS, stock prices and cash flows have a positive relation. Therefore, the managers can rely onto profit maximization which would than raise the Net Income and thus the EPS. This would than affect the cash flows and the stock prices positively, hence raising the wealth of the shareholders. Thus, effective financial management through proper utilization of capital budgeting and an optimal capital structure can result in the minimization of the agency problem by achieving the goals of both the shareholders and the managers. 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