Financial Crisis in Capital Structure Decision-Making - Essay Example

?IMPACT OF FINANCIAL CRISIS ON THE CAPITAL STRUCTURE DECISION MAKING OF THE FIRM INTRODUCTION Capital structure of the firm is a dynamic decision andthis decision faces impact from large number of factors (Miglo, 2010). Accounting for the wide variety of factors both internally and externally, firms’ capital structure responds to changing dynamics. Capital structure theories have developed framework for defining aspects and patterns of capital structure as well as response to changing dynamics and hence, owing to the financial crisis and distressed period the capital structure of the firm have also shown responses. The underlying discussion has developed the reference from the literature related to the capital structure theories and the brief about the financial crisis of late 2000s. The discussion also addresses the firms’ response to the financial crisis by adjusting mix of the capital structure. Therefore, for clear assessment along with overall global assessment, capital structure adjustments of Tesco and Dell have been discussed in the report. The report also has presented alignment of the responses of the capital structures with theories. FINANCIAL CRISIS Financial crisis have always been the dominant factor for determining trends and practices in the economic scenario. A financial crisis traces the reasoning from the excessive loans such as sub-prime mortgages as well as financial instrument of debt derived from such loans (Mizen 2008). Crisis originated from US in late 2000s spread across Europe and then to world owing to the benefit of diversification that businesses attempted to gain from spreading risk across local and international markets (Fosberg, 2010). First strong hit from financial crisis and its intensity was revealed in late 2007 upon the Bear Stearns’ declaration about evaporation of the value of major assets held by Bear Stearns’s hedge funds. The impact being nationwide further became evident upon the auction rate securities as market collapsed in early 2008 and finally noted the bankruptcy filing from Bear Stearns within eight months of first trouble claim from firm. JP Morgan Chase entered as buyer with finance being provided by NY Fed to buy Bear Stearns’s shares and sustain the market. However, the impact of financial crisis then resulted in continuity as Fannie Mae and Freddie Mac declared bankruptcy in third quarter beginning of 2008 followed by government takeover. Similar month also witnessed another major shock from financial crisis as Lehman Brothers declared bankrupt and immediately next day another giant AIG ended up receiving $85 billion credit facility from NY Fed to sustain. Efforts to sustain the steep fall of the financial stability of bank and institutions Troubled Asset Relief Program (TARP) was launched (Fosberg, 2010). TARP performance has also been bringing losses to treasury as TARP invested US $25 million in the bank while managed to fetch only US $13.5 million on sale of preferred stock of invested in financial institutions. TARP is also actively making efforts in closing down its program for banks though it still held the share for 199 banks (Sparshott, 2013). Being international firms, all these apart from impact on local financial market had detrimental impact on the international financial markets and hence international firms locally. Estimation of the reasons of the financial crisis, other than the core reason of subprime loans backed by subprime mortgages, has been found many. Such as among various factors discussed for fact has been the claim to the performance of respective roles of asymmetric information etc (Miglo, 2010). Further, another core factor along with dominant role of agency problem mounted the issue. Agency problems’ role was initially ignored to be addressed for the level of attention required (Miglo, 2010). In addition to these, role of already stressed factors such as taxes and bankruptcy cost in capital structure theories were receiving less attention in operational practices and hence contributed to the financial crisis. CAPITAL STRUCTURE THEORIES Capital structure, in the simplest terms, is defining model for the right hand side components of the balance sheet. The entire spectrum revolves around the suitable combination of two components i.e. debt and equity. Apparently simple, yet complex decision of the combination of debt and equity the most suited for the firm results in determining the value of the firm. Hence, financial literature provides various theories that support the determination of the component of debt and equity and thus this combination determines the capital structure of firm. Four Capital structure Theories have been discussed in brief in underlying section: Trade-Off Theory (1973) Trade-off theory has been among the central theories of corporate finance related to determining capital structure of the firm. Trade Off theory was presented by Kraus and Litzenberger in the year 1973. As the firm intends to maximize value and MM theory that pioneers the capital structure theories states that firms ignores the fact that moving towards higher debt increases risk of the firm. Trade- Off Theory asserts that firm’s capital structure is a mixture of debt and equity while this mix is determined by benefit from tax shield, bankruptcy cost rising from over burdening of firm with debt, agency cost and the cost of the debt itself. The rising bankruptcy cost includes cost to lawyers, declining investors’ confidence on the firms etc. The trade off theory hence has following driving and determining factors for debt: Higher bankruptcy cost leads to low debt in firm (Frank and Goyal, 2007). High taxes results in providing high tax shield increases debt component. Graham and Harvey (2001) presented survey that 45% of CEO agreed on the defining role of rate of tax on capital structure. Debt level in firm’s capital structure is inversely related to the profitability of the firm as empirical evidence predicts (Frank and Goyal, 2007) Capital Structure of firm is debt driven based on the target level of debt (Leary and Roberts, 2005). Agency cost determines the level of debt in the overall capital structure. Miglo (2010) also mentions various factors that added to trade off theory for determining the level of debt. Pecking-Order Theory Pecking Order theory adds to the corporate finance that decisions to raise the capital and hence continuity in determining the capital structure has been based on priorities in adopting sources of capital. The referred prioritization of the capital sources follows investing from internal sources and maximizing value of shareholders for every requirement of capital investment. In case of non availability of the internal resources of fund, the capital projects shall focus on securitization with respect to moving the highest level of safe modes to the lowest; i.e. moving with debt then to equity while each level of debts shall also follow similar levels of risk taking from the lowest to the highest. Level of safety is determined by wide variety of factors such as cost of forms of capital, impact of signaling effect (security price response to the announcement of issues), agency cost, symmetry of information available, debt and equity capacity (quality of firm determining the adoption of source of financing based on the firm profitability) etc (Miglo, 2010). Miglo (2010) adds the dynamics to the theory such as time period of the asymmetric information. Contrasting behavior of the firms in industries than one determined by Pecking Order Theory is based on the high level of uncertainty related to growth rates of firm (Miglo, 2010). The role of risk factor related to mispricing is also important in determining the trend for raising capital for the project unlike Pecking order Theory as discussed in the research of Halov and Heider (2006). Signaling Signaling theory, if simply stated, refers to signaling investors about the private information of the firm. These signals are generated from the announcement of firms related to issuance of debt or equity or investing internal or external funds etc. The signaling theory declares that share price of firm receives positive reaction generated by investors upon the announcement of debt issuance whereas the share price of firms reacts negatively upon the declaration of firm to issue equity. Signaling theory is also supported by activities of the firm to increase leverage by other activities than only debt issuance (Antweiler and Frank, 2006) and hence activities related result in increasing debt and generates positive response from market. Further, market response is negative in case of activities that result in change in capital structure towards leverage decreasing form. Hennesy et al (2005) developed a dynamic model of the firm under repeated hidden information. The dynamic model discussed in the Miglo (2010) referred the positive information signaled from the debt substitution for equity and therefore firms with negative private information are less leveraged. Signaling is also affected by the level of information with investors. Low cost of being informed and high level of uncertainty pertaining to the prospects of firm are also signaled and firm may issue high information sensitive security i.e. equity form of capital raising that leads to information production from specialized institutions and hence outside investors (Fulghieri and Lukin, 2001). Inderst and Mueller (2006) in the referred context of information have referred that projects that are considered safe investments are the ones that are financed by debt. Moreover, they have claimed that financing from equity is concerned to higher level of risk. In this case, low level of risk as well as safe investment refers to hard and concrete information availability whereas risks that project may not achieve break even based no verifiable information are high risk projects (Inderst and Mueller, 2006). Market Timing The market timing theory focuses on the aspect of the capital structure decision based on the market timings where the timing indicates the performance of the market at time of capital structure changing activity. Baker and Wurgler (2000) have supported the proposition that business cycle is negatively related to the capital raising i.e. in case of booming conditions of the economies, generally businesses tend to raise capital with equity while in the middle stage of economy’s performance some of the firms are more likely to issue equity. However, in the down side of economic performance, capital will be raised with debt form. Market timing to issue raise capital is also affected by the market timings as well as level of valuation from the investors. Firm on equity issuance takes the benefit of over valuation caused by over optimism of the investors as well as highly positive recommendations from managers (Baker and Wurgler, 2002); however, this is always not the case. Chang et al. (2006) with respect to benefit from the market timing states that firms with high asymmetry enjoys higher chances to take the market timing benefit whereas firms with lower asymmetry of information. Further to take advantage of the market timing and investors prediction firms before issuing equity attempt to use techniques such as window dressing in order to improve and inflate their performance. Overall discussion of the theories presented predictions based on the firms attributes related to capital structure. Further, direct relation of the economic conditions and capital structure transition, activity of increasing of capital by firm has been discussed in the market timing theory only. CAPITAL STRUCTURE RESPONSES TO CRISIS PRIOR THAN LATE 2000s Capital structure of the firm underwent significant changes over a period of financially distressed situation of the economy. Fosberg (2010) has developed an assessment of the changes in the capital structure of the firm owing to financial crisis and stated increased debt in the capital structure of firm. Accounting to the impact of recession along with financial crisis, the increase in market debt of the firm was almost 5.5% while increase in debt component of the capital structure trimming off recession impact has been 5.1%. These results have been developed for almost 4,008 to 5,452 firms from all sectors excluding financial sectors and utilities industries from a time period of 2001 to 2010. The results arrived from measuring the market debt ratio of the firms over mentioned period have been confirmed by measuring book to debt ratio. Consistent with findings stated above equity issued in 2007 remained U.S. $876 billion while within year global equity issuance declined to U.S. $471 billion only; therefore showing a decline of 46.2% within a single reporting year (Fosberg, 2010). The capital structure activity also witnessed considerable declined in the debt issuance within a single year from $6,634 billion in 2007, 36.0% downside and 2008 noted debt issuance of only U.S. $4,244 billion (Fosberg, 2010). The comparison of debt versus equity issuance over 2007 to 2008 have shown drastic changes from 7.57 dollars of debt raised over equity in 2007 increased to 9.01(Fosberg, 2010). Fact that confirmed these changes being the central impact of financial distress are results of firms reverting back to reduced debt structure as the crisis were bound. After decline in 2008 to U.S. $471 billion investors regained and equity issued in 2009 globally was U.S. $903 billion and while in 2010 it was U.S. $893 billion; though lower than 2009 but still higher than 2007(Fosberg, 2010). Similarly, debt issuance rebounded in $6,112 billion in 2009 while $6,048 billion in 2010; however, these levels are lower than debt issuance in financially distressed period. In addition to this, debt versus equity issue also declined to 6.77 in the 2009 and remained at similar level in 2010 (Fosberg, 2010). Hence, debt orientation of firms globally in the years of financial distress has increased as compare to equity orientation in the similar period where as soon as the crisis rebound the capital structure mix reverted back to the previous levels that can be described as the target capital structure of firm. In addition to global scenario described above, firm specific example of Tesco has also been assessed. Tesco is the leading retailer in UK and it is ranked among the leading retailers of the world. The annual report assessment of the Tesco for the period of operational activity before and after recession has been conducted as follows: The performance of the Tesco before, at and after the financially distress period has been presented. Tesco has leverage of between 55% to 60% before the recessionary period. As the financial crisis hit market, debt percentage increased to more than 60%; as 61% in 2008; further, anticipating length of the economic pressure from recession Tesco further increased debt section of the capital structure to 72% with steep increase of 12% within a single financial reporting period. Debt over equity ratio also jumped from 1.35 in 2007 to 1.50 in 2008. Further, reflection of the increased debt by almost 12% from 2008 to 2009. The ratio has increased to 2.54 from 1.50. Upon expected recovery (or anticipation of recovery) the structure has showed reversal and debt to equity ratio declined to 2.13 and then to 1.84 in 2010 and 2011 respectively with leverage percentage declined to 68% and then to 65% over similar period of reversal. Also noted performance of the earning per share of the Tesco has remained consistently increasing over the mentioned period from 16.31 pounds sterling to almost double of 32.94 over the whole period of assessment. While share price has remained to respond to the changing market as well as capital structure decisions. Another company that has been analyzed for this purpose is Dell. Important financial ratios of Dell have been shown in the table below: Dell 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Debt to total assets 67.48 72.07 82.13 83.12 86.45 83.88 83.24 79.88 79.98 77.53 Debt to equity 0.08 0.08 0.12 0.13 0.1 0.44 0.61 0.66 0.72 0.49 EPS 1.01 1.18 1.46 1.14 1.31 1.25 0.73 1.35 1.88 1.35 (Morning Star, 2013) It can be seen that the debt of the firm has increased from 2003 till 2011. From 2011 and onwards as the economic situation has started to show slight improvements, the debt of the firm has started to decline slightly. Therefore it is showing that as the economic crisis occur, the firm has increased its debt in the capital structure. Moreover, the debt to equity ratio has also increased from 8% in the year 2003 to 72% in the year 2011. Therefore showing that there has been a drastic change in the capital structure of the firm and with the economy going through recession, the debt has increased drastically. And as the economy has started to show some improvements the debt to equity of Dell has decreased. Earnings per share of the company decreased after the financial crisis in 2007. EPS in 2007 was 1.31 and then it decreased to 1.25 however the firm has managed to maintain the overall EPS and even increased as shown in 2011 and 2012. The performance of these firms has moved towards debt in accordance with Trade off theory is supported by fact that increased debt provides tax shield and in distressed period such tax shields increase saving for sustaining operational efficiencies evident in rising earnings per share. Further cost of debt being lower than equity is also evident factor. Also supported from Tesco and Dell examples; increased debt has supported these firms in constantly increasing or somewhat maintaining earnings per share even in financially difficult times. Further sustained performance is gained in distressed period at higher agency and bankruptcy cost; therefore, upon recovery firms move back to the target level of debt in line with debt conservatism (Miglo, 2010; Leary and Roberts, 2005). Further, the earning performance of the Tesco is also in line with agency theorist that supports higher debt (Hackbarth, 2008). Higher debt orientation, in line with pecking order theory is attributable to the overall performance of market globally as well as for Tesco and for Dell. Increased debt is adopted in when economy is not performing well as whereas equity is raised in sound economic conditions (Choe, Masulis and Nanda, 1993). Since the period after recovery has not reached boom; therefore, high equity rising has not taken place. Further, claims made by Halov and Heider (2006) support the performance of Tesco and Dell and it is in line with Pecking Order Theory proposition of sequence as risk of adverse selection, that requires raising equity, is low with Tesco. Closely in accordance to the core of signaling theory share price of Tesco responded to the changing capital structure with changing debt component. However, the greater deviation is attributable to the market crunch as well. Further, Tesco being large firm and under constant assessment from investors and analyst; therefore, increased debt is supported by factor of hard information available about the project (Inderst and Mueller, 2006). Finally, in line with market timing theory, overall global performance has shown debt rose heavily. Further, Baker and Wurgler (2000) proposition is also evident as in economic distress debt is heavily raised whereas as the market overall has moved to the middle performance of raising mix of debt and equity as economy has shown some signs of recovery from distress. Along with the alignment of the market and Tesco and Dell performance with capital structure theories, European property industry has some deviations as collected in evidence from survey. Firms surveyed states following reason for debt orientation as prioritized: (Deloltee, 2011) While following factors determine the level of debt in the overall industry: (Deloltee, 2011) Hence, the above presentations along with Tesco as well as Dell performances witness that overall trend remains the same across board; however, none has struck following to the capital structure theories only. CONCLUSION Capital structure of the firms is designed based on large number of factors. These factors arising from firm’s internal and external environment are not consistent throughout life of the firm and keeps on adjusting to the changing dynamics. Among various factors posing an impact, the underlying report discussed an impact of financial distress on the capital structure of the firm. Firms in the economic crisis period are more prone towards debt orientation as has been presented in the theory and while all firms do not actually conform to all aspects of theories. Therefore, broadly, theories are followed along with fine tuning with respect to firm’s conditions. References Antweiler, W. and Frank, M. (2006). Do U.S. stock markets typically overreact to corporate news stories?. Working paper, UBC and University of Minnesota. Baker, M., and Wurgler, J. (2002). Market timing and capital structure. Journal of Finance, vol. 57, pp. 1-32. Chang, X., Dasgupta, S., and Hillary, G. (2006). Analyst coverage and financing decisions. 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