The Capital Structure - Essay Example

The Capital Structure Capital structure refers to the way in which a company is financed by a mix of long term capital such as ordinary share capital, reserves, debentures, etc and short term financing such as bank overdraft. Companies use different financing decisions based upon the investment opportunities and the company’s current capital structure. Each sort of financing has its implications. Debt financing is deemed to be less risky for the debt holder as it includes interest and it can be secured. The cost of debt to a company is therefore relatively less than equity financing. Besides this, debt is considered cheaper by the providers of finance and its attracts tax relief on interest payments. The greater the level of debt, the more will be the financial risk to the shareholder of the company. Hence the return required would be higher. This also helps in establishing the gearing mix of a company. The higher a company is geared, the higher would be the risk involved. There are many factors that contribute towards the availability of different sources of funds. Gearing is one major issue which has a critical effect onto the capital structure of a company. The higher a company is geared, the more difficult it would be for the company to raise debt finance as the institution giving out the debt would be exposed to greater risk. One view is that there is an optimal capital mix at which the average cost of capital, weighting according to the different forms of capital employed, is minimised. As gearing increases, the return expected by ordinary shareholders begin to rise in order to compensate them for the risk resulting from a larger share of profits going to the providers of debt. The cost is comparatively lower than the cost of equity because debt is relatively less risky from debt holder’s point of view as a debt would give the debt holder the legitimate amount of debt to which he/she is entitled to, besides the interest income, the debt can be made secured. Interest rates are usually higher on long term debt as compared to short term debts as the lender would require the compensation for the increased period of time he/she is deprived of his/her funds. A company find itself committed to long term debts with adverse interest charges and huge penalties if the debt is paid up early. Inflation and uncertainty about changes in future interest rates are one of many reasons why companies hesitate to borrow long term debts at increased rates of interest and investors too are unwilling to lend long term when they consider that interest yields might even go even higher. ({BURTON et al (2003); Goyal et al (2005); Darren (2006)} A choice of capital structure usually depends upon the company and its management. The attitude of the shareholders and directors towards risk and return makes up in deciding upon the different sources of funds, if the directors and the shareholders are cost conscious, they would definitely favour debt financing as a source of funding as it is less costly. If the management and shareholders are concerned about the dissolution of power and authority, equity finance would definitely not be the mode that would be used by the company as equity financing would lead to issuance of more shares leading them to be more diluted hence the power of the shareholder would dissolve. Besides such issues, if the shareholders are unwilling to contribute further funds, in the form of right issue, equity financing would automatically be discouraged as a mode of finance. { SCHLINGEMANN (1998); Kuhn (1990); Goyal (2005)} If the stock market is depressed or the economy is facing a huge recessionary fall, it may be difficult to raise finance through equity financing. Even if shares are issued, they may be issued at lower price to attract more investors hence leading to dilution in the value of current shareholding. On the other hand it may be difficult for companies to raise debt if a company is facing financial difficulties or has a poor credit rating. The other issue that directly dampens the choice of debt financing as a mode of financing is the fact where a company is facing restrictions written onto existing loan agreements prohibiting the company to take out further loans, such restriction usually occur when certain conditions are not fulfilled by the company such as increasing a specified gearing limit. A highly geared company should earn enough profits to cover its interest charges before anything is available for equity. Usually companies tend to calculate the returns expected by any venture in which they are investing, is the returns are higher than the cost of those borrowed debts, the company takes pleasure of the increased return, as a result of this, introducing financial gearing into the capital structure into the capital structure enables the earnings per share to be increased. (DeAngelo et al, 2006) Weighted Average Cost of Capital (WACC) is a weighted average of different sources of finance used by any particular company. Increased level of debt financing leads to a reduction in WACC as debt financing is cheaper than equity because it carries less risk and it attracts a tax relief on interest payments but the contrasting element is that increased levels of debt makes equity more risky as a fixed percentage of the profits is to be paid as interest, hence increasing gearing increases the cost of equity and that would increase the WACC. The scenario here is that, on one hand, the cheaper debt tends to reduce the WACC but on the other, the increase in finance risk (fixed commitment of interest paid before equity) increases the WACC. Many different theories have tried to answer this particular scenario as to which thing has a greater effect on the Weighted Average Cost of Capital. The traditional view in this respect is that, at lower gearing level, shareholders perceive risk to rise marginally with the rise in gearing hence the issue that debt is a cheap form of finance dominates resulting in a lower WACC but at high gearing levels, shareholders become more concerned with the instability of their returns as interest becomes a fixed commitment and is paid firstly. This issue of the shareholders dominates the cheapness of the extra debt so the WACC increases with the increase in gearing. At one point where the gearing goes to the highest level, the debt holders along with the shareholders get concerned with the increasing level of gearing, hence leading to an increase in the cost of equity along with the cost of debt. (Mitchell Petersen et al, 2006) The Modigliani and Miller Theorem suggests that the WACC is not influenced by changes in a company’s capital structure and the issue of debt causes the cost of equity to rise in such a way that the benefits of debt on returns are exactly offset. As a result, the investors set their own level of gearing irrespective of the company’s level of gearing. The issue with the original Modigliani-Miller Theorem is that it contains few subjective assumptions. Firstly, it assumes that investors willing to invest operate in a perfect market where complete information is available to all impartially. Secondly, the transactions cost are ignored and finally the taxation effects are also ignored. With taxation being ignored in the original Modigliani-Miller Theorem, the tax benefit on the interest payments would not be achieved. In practice, companies do not keep a high level of gearing as suggested by Modigliani-Miller theorem because of many factors such as: Agency Costs Many conditions are kept by the debt holders so as to restrict a company’s freedom of action. Risk of Being Insolvent The rise in gearing leads to a greater possibility of bankruptcy. As a result, shareholders increase the WACC and reduce the share price. Tax Exhaustion After a certain level of gearing, company would realise that it left with no tax liability to offset the interest charges against. Borrowing/Debt capacity High levels of gearing are unusual because companies are not left over with suitable assets to provide as collateral against loans. Hence, companies with assets having good market tend to have a better borrowing capacity. (LEWIS, 1964; LYNN et al, 1994) The Trade-off theory in contrast to the Modigliani-Miller theory argues that companies in a static position will adjust their current level of gearing to achieve a target level. If a company is in a stable position, it is likely to have a stable debt policy. This theory assumes that such a policy will be based upon the balance between the benefits and the costs of issuing debt. This theory provides a good theoretical basis for looking at capital structuring decision by firms but practically this is not seen in companies as in some industries, the most successful companies are usually those which have a low level of gearing and this is a negative image of the static trade off theory. Besides this many companies rarely do take up equity financing clearly showing that financing methods are not driven by any considerations to optimal capital structure. (LEWIS, 1964; LYNN et al, 1994) The pecking order theory on the other hand explains the reason of companies not behaving as per the static trade off theory. This theory states that companies have a preferred hierarchy when it comes to financing decisions: 1- Internally Generated Funds 2- Debt 3- New issue of equity This pecking order theory was developed to show the inconsistency between the trade off theory and the practical solution preferred by companies. Usually, companies tend to look at the issue costs, the issue costs for internally generated funds (such as Retained earnings) are lower, hence the company prefers it above all other modes of financing. Debt, on the other hand has some increased issue cost compared to internally generated funds and equity financing carries the highest level of issue costs amongst the three choices. The implications for investments are: A project’s value is ascertained by its mode of finance. Few projects are only taken up if they are funded by a safer mode of finace such as internally generated funds or debt financing. Higher gearing level will lead companies to under invest. If a firm follows the pecking order theory its gearing ratio results from a set of incremental decisions without any aim of getting to a target and there may contrasting times such as good or bad depending upon the level of information available in the market. (Murray et al, 2003) Myers and Majluf demonstrated that with asymmetric information, the market thinks of new equity issue as an alarming situation when shares are overpriced. On the contrary, Bennett Stewart (1990) came up with the thought that new equity issue would raise doubts that the management of the company may be trying to polish up a company’s financial resources for bad times in the future by selling of overvalued shares in the current period. The other theory given by Asquith and Mullins after major observation and experience suggested that the announcement of new equity shares is welcomed by quick reduction in the prices of stock. Thus, equity financing is comparatively rare among large established organisations. (DIERKENS, 1988) REFERENCES BURTON, B. M., & POWER, D. M. (2003). Evidence on the determinants of equity issue method in the UK. Applied Financial Economics. 13, 145-157. DeAngelo, Harry, and Linda DeAngelo, 2006, , payout policy, and financial flexibility,Working paper, University of Southern California. DIERKENS, N. (1988). A discussion of exact measures of information asymmetry: the example of Myers and Majluf model or the importance of the asset structure of the firm. Fontainebleau, France, INSEAD Faulkender, Michael, and Mitchell Petersen, 2006, Does the source of capital affect capital structure? Review of Financial Studies. Frank, Murray Z., and Vidhan K. Goyal, 2003, Testing the pecking order theory of capital structure, Journal of Financial Economics 67. Frank, Murray Z., and Vidhan K. Goyal, 2005, Capital structure decisions: Which factors are reliably important? Working paper, University of British Columbia Kisgen, Darren, 2006, Credit ratings and capital structure, Journal of Finance 61. KUHN, R. L. (1990). Capital raising and financial structure. The Library of investment banking, v. 2. Homewood, Ill, Dow Jones-Irwin. Leary, Mark T., 2006, Bank loan supply, lender choice, and corporate capital structure, Working paper, Cornell University LEWIS, W. S. (1964). An empirical test of the Modigliani-Miller model of market valuation of growth firms. Thesis (M.S.)--Massachusetts Institute of Technology, School of Industrial Management, 1964. LYNN, R., & DWYER, H. J. (1994). Fama and French's tests of the Capital Asset Pricing Model and the Modigliani and Miller Models of Capital Structure the consequences of interdependence. New York, Center for Applied Research, Lubin School of Business, Pace University. SCHLINGEMANN, F. P. (1998). Sources of financing and corporate investments: the case of acquisitions. Thesis (Ph. D.)--Ohio State University, 1998 Read More