The Theory of Optimal Capital Structure - Coursework Example

Capital Structure is the mix of debt and equity that a firm uses to raise capital. Debt financing is done through obtaining loans and other forms of credit whereas equity financing is done by issuing shares. In debt financing, the creditors are to be paid before the shareholders in the event of bankruptcy whereas in equity financing, there is no direct obligation to repay the funds. The equity investors become part-owners and partners in the business and tend to exercise some control over how the business is run. The capital structure is signified by the firm’s debt-equity ratio and gives an insight as to how risky the firm is. Capital Structure is important because: It gives the Weighted Average Cost of Capital (WACC). If the firm needs to have the lowest WACC, it should design its capital structure in such a way that the debt equity ratio is high which would bring down the WACC. Free Cash Flow = Cash flow generated – Invested Capital outflow Dividend policy is based on capital structure. The Optimal Capital Structure is that mix of debt and equity that maximizes the firm’s value or minimizes the cost of capital. There is no standard mix of debt and equity that maximizes the firm’s value, but each firm should strike a balance between risk and return thereby maximizing the share price, depending on its size and financial position. The amount of debt that a firm uses is called leverage. High leverage means high risk for the company. Below are some of the advantages and disadvantages of using debt financing: Advantages: 1) Creditors require a lower rate of return than ordinary shareholders. 2) The debt interest can be off-set against pre-tax profits thus reducing the amount of tax deducted and leaving more of after-tax profits for the shareholders. 3) Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares. 4) The owners are able to make key strategic decisions and also to keep or re-invest more company profits. Disadvantages: 1) If the firm size is small, it is difficult to make regular principal and interest payments in the event of shortages in generating substantial cash flow. Such firms face heavy fines and penalties by the creditors. 2) Debt financing signifies high risk for the company. 3) The creditors are to be paid before the shareholders in the case of bankruptcy. 4) Small firms also face difficulty in raising debt since lenders seek security of their funds and look at the financial position and stability of the firm before issuing loans. Since equity financing is done by issuing shares to the public, it also has some pros and cons. Below are some of the advantages and disadvantages of raising capital through equity. Advantages: 1) Using more of equity financing raises the share price. 2) Small firms which struggle with cash flow initially use equity rather than debt because there is no obligation to repay the money. 3) Outside investors that become part owners of the company through the share issues, often prove to be a form of good advice and contact for small business owners. Disadvantages: 1) The founders have to give some control of the business to the new shareholders who now also have a say in the business. 2) Some sales of the equity, such as Initial Public Offerings (IPOs) can be very difficult to administer. 3) If the investors have a different opinion as to how the business should be run or about the day-to-day operations, then this can create problems for the owners and conflicts can occur. 4) Dividends paid on stock are not tax deductible. Following are some of the capital structure theories: Modigliani and Miller’s (MM) Theory: It states that there is no difference whether a firm raises capital through debt or equity and that it doesn’t affect the value of the firm. The Assumptions of this theory are: No taxes No cost of raising debt No bankruptcy costs. All investors have the same information as the management of the firm about future investment opportunities. Trade-off Theory: Maximum debt can be raised when the share price is at its maximum. If the firm raises any more debt, the share price will decline. The point where share price is maximum, it is the trade-off point; risk and return are both at their peaks. Any change would cause a disbalance in the position of risk and return. The maximum risk involved is that of bankruptcy and the maximum return is the maximum value of the shares. Below is a graph that depicts the trade-off between risk and return. Do Debt Signaling Theory: This theory states that when the firm issues bonds for debt financing, it sends out a positive signal in the market. The cost of borrowing will be low as compared to the return the firm will get by putting money in that project. When the firm issues shares for equity financing, it gives out a negative signal in the market because it reflects the credibility of the company and insinuates that the firm cannot raise finance by borrowing from the market and that it is in dire need of funds. The factors that determine the capital structure decision are both internal and external. Following are the internal factors that affect capital structure decision: 1) Matching fluctuating needs against short-term sources in cases of seasonality. 2) The degree of financial risk inherent. The increased financial risk that comes with increased use of debt tends to moderate the use of debt in the firm’s capital structure. 3) If the motive is to increase owners’ profit. 4) Surrendering operational control. If too much debt is taken to raise capital, then the control is surrendered to the creditors which can prove to be disastrous. 5) Future flexibility. The firm should leave room for maneuvering and have flexibility in the capital structure so that in the event of unfavorable circumstances, the firm is able to pull out rather than sink. Flexibility comes from investment by the shareholders themselves rather than relying on borrowed funds. Following are the External factors affecting capital structure decisions: 1) General level of business activity such as recession or otherwise in the economy. 2) The level of interest rates. When interest rates are up and employment down, it is not preferable to issue or buy shares and debt financing should be used. 3) Level of stock prices. In case of availability of funds and interest rates going down, equity financing should be used as generation of profit increases and debt financing becomes expensive. 4) Availability of funds in the market. 5) The tax policy on interest and dividend. The tax deductibility of interest expense tends to increase the use of debt in the firm’s capital structure. However, if tax concession is not available on interest, it won’t be feasible for the firm to take on more debt as interest is a company’s expense and it is deductible from the firm’s income. There are also some points for consideration when making capital structure decisions which are as follows: 1) Assets in place: If the firm has a high level of assets, lenders do not hesitate in giving out loans and there is high credibility in the market. The firm is also able to get loans at a lower interest rate. 2) Sales Stability: Sales must be stable and growing. If the firm introduces new products or the quality is improved of the existing products, then the prices of the products will automatically go up and sales will improve. Hence firms with stable sales can safely take on more debt and incur high fixed charges as compared to a firm with unstable sales. 3) Growth rate in profits, assets and market value of shares: If the firm’s growth is steady in the short-term, then it is very likely that the firm will be able to get loans if it opts for debt financing. 4) Tax policy: Firms with high tax rates prefer debt financing because interest is a deductible expense and deductions are most valuable to such firms. 5) Financial Soundness: If the firm is in a sound position, it is able to bear the debt cost in the event of taking loans for financing without the fear of incurring losses. The debt equity ratio is calculated as follows: = Total Liabilities / Shareholders’ Equity A high debt equity ratio signifies that the firm has taken an aggressive stance in raising its capital through debt. By using more debt the firm is able to generate more earnings than could be possible through equity financing because as interest is deductible for income tax purposes, net income attributable to common shareholders is high as taxes are lower. If the firm is able to generate more earnings than the debt cost (interest), then the shareholders benefit as more earnings are being shared by the same number of shareholders. However, in case of the earnings generated from the debt taken, is less than the debt cost then this might lead to bankruptcy and leave nothing for the shareholders. The debt equity ratio differs from company to company depending on various factors namely: Type of Industry: Companies across different industries have different debt equity ratios because of the way they operate. For e.g. firms operating in capital intensive industries generally have a high debt equity ratio as compared to those operating in labor intensive industries. Size of the firm: If the firm size is small, it is difficult for it to raise capital through debt and hence it has a low debt equity ratio in contrast to a large-sized firm. Time in the market: If the firm is relatively new in the market, lenders will be hesitant to lend money since there’s no guarantee of timely principal and interest payments. Such firms will use more of equity financing, having a low debt equity ratio till the time their credibility is established in the market. Style of Management: If the firm has a conservative style of management, it is most probable that equity financing will be preferred leading to a low debt equity ratio because more debt brings on more risk for the firm and the management may want to be prudent rather than opt for high returns. Credit Ratings: Loans will not be disbursed to a firm with poor credit ratings and the firm would need to do equity financing to raise capital; this would lead to a low debt equity ratio. However a firm with a good credit rating in the market would have a different capital structure altogether and could either have a high or low debt equity ratio depending on its source of financing. Bibliography: Brigham, Eugene. F and Michael C. Ehrhardt. Financial Management Theory and Practice, 10th Edition Brealey, Myers, Marcus. Fundamentals of Corporate Finance, Third Edition. Van Horne, James. C and John.M. Wachowicz. Fundamentals of Financial Management, Eleventh Edition. Read More