Optimal Capital Structure Analysis - Essay Example

FINANCIAL MANAGEMENT By of the of the of the School 16 April Part A: Critically evaluate and analyse whether an optimal capital structure does exist Businesses and firms require capital for start-up and expansion of their operations. The capital structure has been employed by most organizations to finance their assets. The financing decision establishes what mixture of equity and debt capital is a suitable proportion for the firm. Optimal capitals structure describes the best equity debt ratio that maximizes the value of the firm. The concern is how the finances are raised and what factors drive to the managers’ decision for the chosen mix ratio. The next section critically evaluates whether optimal capital structure exists for individual companies. Trade off theory The theory acknowledges the use of both equity and debt financing of the firm operations. It holds that each firm has an optimal capital structure at which it maximizes the value of the firm, which is the point when the attractiveness of each additional debt unit declines, upon balancing its costs and benefits it brings to the firm (Ghazouani, 2013). By this the theory links a firm’s financial leverage to its profitability and optimum debt ratio. Proponents of the theory argue that debt financing can enable firms to achieve maximum profitability and value by making a trade off of the accrued benefits and cost. Financing firms with debt has the advantages of corporate tax benefits of the debt, but also suffer risks from bankruptcy and agency costs, which create financial distress for the firm. Tax shields are firm specific factors that influence firms financing decisions. Firms may choose to take additional debt with increases to tax shield offered. According to Chen, “the trade-off theory predicts that firms will increase their debt level to capture fully tax benefits until the expected marginal benefits are equal to the expected marginal costs of debt” (2012, p. 1). The higher the tax rate the greater the firm’s leverage and effectively a higher enterprise value. By maximizing the use of debt, firms on the other hand become more prone to losses due to increasing risks of bankruptcy. The firm’s over-borrowing could result to failure of paying the principle, chances of defaulting, and in the event of financial distress are unable to get extended credits from financial institutions, failure to pay dividends or attractive for investment (Kim, Heshmati and Aoun, n.d.). In turn they affect the firm’s profitability, performances and its value. Holding other variables constant, a point comes when a further debt increment becomes inversely and directly proportional to its marginal profits and costs, respectively. (IIgaz, 2014). The value of unlevered firm (Vu) will increase with each unit of a leveraged debt, but begin to decline after the point of optimum capital structure and bankruptcy costs expand. The existence of such a trade-off does show there is that optimum capital structure at which the firm can optimize its value. However, due to recurrent economically influenced event, most firms end up operating below their optimal debt ratio and capital structure, but attempt to remain closer to it. WACC calculation Irrespective of the order that a firm uses to externally finance its investment, the financing decision affects the firm’s weighted average costs of capital (WACC). Both debt and equity are weighted in proportion to the market values. In reference to the trade-off theory, tax benefits make debt financing attractive, and as more debt increases, the firm’s WACC responds inversely proportional to it. Although the component costs of WACC increases, their negative impacts are offset by the tax benefits. WACC calculation demonstrates existence of an optimal capital structure at the point where a company’s WACC is minimized, which translates to the firm’s maximized value. The challenge for the firm is to establish which equity and debt ratio best computes to the least WACC. Based on Acca global discussions, firms respond by gearing up, which entails “replacing some of the more expensive equity with the cheaper debt to reduce the average, the WACC” (2009, p. 79). Factors to consider entail financial risks to shareholders, concerned with volatility of their dividend payments and destruction of value by increasing debts. Adjustments of debt and equity ratio lead to changes in WACC. The minimized WACC can be established at the point of optimum debt ratio, past which additional debt leverage causes WACC to soar while the rising costs outweighs the tax benefits. Its shows that a diverse range of capital structures are available for the firms, and considering debt and equity adjustments an optimal capital structure does exist with reduction of WACC. Pecking order theory Unlike trade off theory, the pecking order approach demonstrates inexistence of optimal capital structure. Under pecking order developed by Myers and Majluf, it does not project clear debt and equity ratio; rather it gives a prediction of strict preference of firms financing instead of optimal capita financing (Chen, n.d.). The idea is that firms opt to use internal financing first, going for the retained earnings, dividends and effects of depreciation to finance their investment opportunities. This strategy is known to be economical and capable of retaining the competitive advantage of the firm because floating costs are not incurred and does not require disclosure of proprietary financial information. When the funding is not enough, they resort to external finances, preferring debt issues before equity funding. If debts must be used, firms would prefer short over long term debt. The order follows use of safest securities firsts towards the risky ones. Therefore, a firm may prefer debt, then convertible securities, quasi-equity instruments before using equity/common stock. Information asymmetry is a major influence of the firms’ pecking order financing, where managers of the firms seek to ensure control of the firm and profitability. It is a concept in which mangers of the firms compared to outside investors, tend to better understand and hold more information about the past and present financial performance of the firm and can predict its future growth. Therefore, using internal financing strategy best aligns with the need to keep information proprietary, which is a powerful tool for competitive advantage. Similarly, managers financing decisions respond to the interests of the firm’s shareholders. Because existing investors/shareholders seek out more profits and retaining of ownership, and the managers aim to minimize the exposure of information advantageous to outsiders, most firms may prefer to take safer securities (e.g., debt) over risky ones (equity) even if they show positive NPV. Its undeniable that based on pecking order, debt financing is dependent on companies’ investment and level of internal financing available. Issues of priority in trade off theory like attractiveness of tax shield essential to determinance of optimal capital structure are considered lower in the pecking order. Myers states that “debt ratios changes when an imbalance of internal cash flow occur, net of dividends and real investment opportunities arises” (n.d., p. 85). Debt ratios are hence adjustable over time, but ted to vary with firm specific factors, specifically profitability and size of the firm. Profitable firms tend to have less external financing, implying low debt to equity ratio compared to less profitable ones. Franks and Goyal’s test for pecking order theory of debt revealed that most small public firms tend to issue equity much frequently compared to large firms (2005). Individual companies are hence in a position to dictate their optimal capital structure at a given moment, because the pecking order system facilitates the dynamics the firms needs to adjust with. Market timing theory Market timing mechanism used by firms influence the managers’ issuance decisions that affect the capital structure’s variation over time. It also does not predict existence of optimal capital structure, but claims the capital structure of the firm to be the outcome of cumulative market timing and financing decisions over time. From this approach, managers of the firms tend to issue equity at the period when the stock/share prices are overvalued and later repurchase them during undervaluation (Baker & Wurgler, 2002). These decisions are no doubt driven by the market valuation with respect to market- to- book ratios. The timing decision for financing exploits temporally mispricing/ fluctuation of equity pricing to accumulate finances for the current and future investments. Guney and Iqbal-Hussain argue that such misevaluation lead to establishment of hot issue markets which affects the firms through “deviation from optimal levels (if existing) of capital structure and also post-issue stock returns” (2007, p. 4). Hence firms will sell their stock at IPO (initial public offering) to rebalance their accounts, which does not necessarily occur towards the target debt ratio or optimal capital structure. Part B: Critically compare and contrast two investment appraisal techniques (Discounted cash flow and ARR methods) Most companies have existing opportunities of investment they can consider and finance in set period. Though some are attractive, they may have hidden expenses, which cannot be detected unless critical appraisal is conducted. Others could be undervalued, but end up most profitable in the short or long term process. The challenge for the firms and their managers is to decide where to focus their investment. Such decisions are supported by the findings from appraisal of the selected investments/projects of the firm. Investment appraisal strategy assesses the possible effects on the firm’s cash flow were it to fund the project. Appraisals evaluate the financial consequences (direct and indirect) and estimate the benefits in financial terms to support the decision making over an investment. Other than supporting decision making, with the extended knowledge, the firm, managers and investors are able to make informed choices to finance the project aware of the potential risks. Different appraisal techniques exists, however this section will compare and contrast NPV which is a discounted cash flow method and ARR technique. a. Discounted vs non discounted nature NPV (Net Present Value) It is a discounted cash flow technique often applied in numerous appraisals of modern projects. It means that the analysis insist on determining the present worth of an investment in consideration to the anticipated cash yields over time. Its calculation is based on the accumulated cash flow of the investment in future. The cash flow is the amount of money moving towards or away from the investing parties. According to Hill and McLaney, “discounted cash flow take into account both the timing of the cash flows and also total returns over a projects life” (2011, p.4). The discounted nature considers the value of certain amount at a defined period in future. In simple terms, for an investment of say $100 into the project at present, with would be worth $110 given a 10 percent interest rate. There is a commercial value for $1000 at present greater than $1000 years later. Meaning, given $100 a years later it would have equated to $90 the previous year. Money hence is taken to have time value in respect to inflation and risk factors in future. This formula: $ 100/ (1+ i) y where i is the interest rate per defined period and y the number of years compute the present value of a $100 investment or the time value of the money for specified years of the project. For example: Investing $250 today at say 10 % interest would yield $25 in a year. Hence $275 one year later is equivalent to $250 at present. And that $302.5 two year later is equivalent to $250 at present, Tracing back, this implies that the present $250 must be the value of $ 206. 61 two years ago. ARR technique Its takes the form of non-discounted cash flow method. Here the timing value of money is not under explicit consideration. The commercial value of the $1000 as given in the example above is assumed to remain same over the predefined future. Meaning a pound in the near future is equated to the value of the pound in the distant future. By ARR giving more weight age to future returns, the technique ignores the value of money over time. In computation, ARR focuses on the accounting amounts like the asset book value and expenses rather than time value of money. Rather than cash flows, it lays emphasis on accounting flows, which the firms’ insiders (executives and managers) are much familiar with. b. Use of value additivity principle NPV utilize value added principle Compared to ARR and other techniques, NPV follows the value additive principle. Hence NPV technique is capable of generating absolute amount of output to compute the NPV of the firm. The concept holds that the NPV of a group of assets (e.g. risky and non-risky assets) or projects equal the sum value of individual assets or added NPVs of each project (Reichling, Spengler and Vogt, 2005). This implies that securities A and B for price p; NPV (A + B) = NPV (A) +NPV (B) p *A + P *B = value of the firm It shows that considering all projects undertaken by the firm, each of NPVs added together would provide the overall valuation of the firm. The technique can hence find the firms value through summation of cash flows and existing securities. ARR technique does not satisfy the value additive principle. Its instead calculates the average return across the years of investments. c. Wealth maximization principle Following the NPV technique, the resulting NPV values guides in taking profitable investments that are consistent with aim of wealth creation for the firm and its shareholders. Provided the NPV of an investment is positive, its suggests value increments of the firms, but most importantly that the investment is capable of generating returns to compensate on initial investment of assets and retain higher profits contributing to larger shares of dividends to the shareholders. According to Dayananda et al., “the shareholder wealth maximization goal state that management should endeavour to maximize the net present (current) value of the expected future cash flows to the shareholders of the firm” (2002, p.3).The measure of wealth creation is fundamental in management practices, which makes NPV highly recommended. ARR technique only clearly projects the profitability of the investment through the appraisal. Critics claim that it lacks the economic rational to connect its acceptance criterion to maximization of the shareholders’ wealth. The focus of the technique is establishment of the investment’s profitability over its life span by factoring in depreciation and avoiding aspects of profit reinvestments crucial to the goal of wealth creation and maximization. d. Acceptance criterion of the techniques To determine whether the investment into a project is worth the risk, NPV technique assesses the feasibility based on the generated NPV figure. The criterion is that where the NPV is positive either equal to or greater than zero, the firm should accept the investment and reject those whose NPV imply negative. If more all compared project have a positive NPV, the best investment is that with the largest positive NPV. The greater the NPV, the more valuable the firm is and maximization of wealth creation. The calculation use following NPV function: NPV = ((B1/ (1+ i) 1) + (B2/ (1+ i) 2) + ....+ (By/ (1+ i) y)) – C Where By represents each stream of benefit i is the preferred discount rate for the investment y is the period (often number of years) C is the cost of the initial investment. Accounting for the present value all future cash flows of the investment and subtracting the initial investment, NPV is produced. For example, company Z is seeking an appraisal for its $30000 investment, worth 10 % cost of capital for the 4 subsequent years. The expected cash inflows are $9000,$11000, $13000 and $12000 for first to the fourth year respectively. C = $ 30000 Total cash inflows/benefits = $45000. It implies that the cash gain over the 4 years = $15000 PV1 = 9000/(1+10/100)1 which is $8181.81 PV2 = 11000/(1+10/100)2 which is $9090.90 PV3 = 13000/(1+10/100)3 which is $ 9767 PV4 = 12000/(1+10/100)4 which is $ 8196.16 Summation of PVs amount to $35235.87 NPV = ∑PV – C which is $5235.87. The investment is already feasible and if this NPV is the greatest compared to NPVs of other investments, the project is best recommended to finance. Appraisal with ARR techniques measures the increases in profits anticipated from a project and holds that an investment with demonstrated return on investment (ROI) greater than the set minimum rate by the firm to be acceptable otherwise it is rejected. Considering the established cash inflow values of company Z above, with same initial investment and scrap value of $22000 after the 4 years, holding that depreciation follows a straight line basis and the set minimum rate to be 25 %, one can calculate ARR and determine the feasibility of the anticipated project. ARR is calculates as: ARR= (average profit/average investment) * 100 Where the average profit is computed by summation of all earnings after interest and taxes shared across the number of years earned, average investment divides the sums of the initial cost and scrap value of the investment by two. You can treat the cash inflows as earning after depreciation and tax. ARR = (((9000 + 11000 + 13000 +12000)/4)/ ((30000+ 22000)/2)) * 100 ARR=43.26%. The company should accept the project the established ARR figure exceeds the minimum rate. Investments with higher ARR are the best ventures based on the technique. Compared with NPV technique, it entails simpler calculations. Variation in result and suitability NPV technique offers the appraisers with consistent results. It not only computes the value of the assets and profitability in an absolute manner, but suitable for appraisal of different size of projects and those which are mutually exclusive because the method is consistent with value maximization (Arshad, 2012). ARR fail to consider the size of the investments of several competitive projects. Because of the variation in the methods of ARR computation, a similar project can yield two differing ARR values. The difference between the two values can bring ambiguity of using the method or lead to wrong choice of the investment upon valuation. However, both ARR and NPVs technique of appraisal are time consuming Conclusion The analysis indicates that capital structures and appraisal methods are critical factors that guide in financial decisions. It indicates that optimal capital structures for individuals firms do exist but due to changing economic and financial events in the firms and market, firms operate below the optimal point as they seek to rebalance their accounts by using their preferred securities. NPV is differentiated from ARR as a discounted cash flow technique consistent with wealth maximization and value additivity principles, employ the time value of money and cash flows, while ARR uses accounting flows. References Guney, Y. and Iqbal-Hussain, H., 2007. Capital Structure and IPO Market Timing. [online] Available at: [Accessed 16 April 2015]. Acca Global, 2009. Optimum Capital Structure. [online] Available at: [Accessed 15 April 2015]. Arshad, A., 2012. Net Present Value I Better than Internal Rate of Return. Interdisciplinary Journal of Contemporary Research in Business Vol 4, no. 8: pp. 211-219. [online] Available at: [Accessed 17 April 2015]. Baker, M.and Wurdler, J., 2002. Market Timing and Capital Structure. The Journal of Finance, Vol 57, no. 1: pp. 1-32. http://pages.stern.nyu.edu/~jwurgler/papers/capstruct.pdf. Chen, L., n.d. How the Pecking Order Theory Explain the Capital Structure. [online] Available at: [Accessed 15 April 2015]. Chen, Y. and Gong, N., 2012. The Impact of Taxes on Firm Value and the Trade-off Theory of Capital Structure. [online] Available at: http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2012-Barcelona/papers/EFMA2012_0544_fullpaper.pdf>[Accessed 14 April 2015]. Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Franks, M. Z. and Goyal, V.K., 2005. Trade-off and Pecking order Theories of Debt. [online] Available at: [Accessed 15 April 2015]. Ghazouani, T., 2013. The Capital Structure through the Trade-Off Theory: Evidence from Tunisian Firm. International Journal of Economics and Financial Issues Vol. 3, No. 3: pp.625-636. http://www.econjournals.com/index.php/ijefi/article/viewFile/448/pdf. Hill, A. and McLaney, 2011. MBA7001 Accounting for Decision-Makers: Week 6 Lecture – Capital Investment Appraisal. http://www.iuc-edu.eu/group/mba_learning/2013%20VARNA%20Accounting/7%20Capital%20Investment%20Appraisal.pdf. IIgaz, D., 2014. Optimum Capital Structure: Why do Firms Borrow. [online] Available at: [Accessed 15 April 2015]. Kim, H., Heshmati, A. and Aoun, D., n.d. Dynamics of Capital Structure: The Case of Korean Listed Manufacturing Companies. [online] Available at: [Accessed 14 April 2015]. Myers, S.C., n.d. Still Searching for Optimal Capital Structure. [online] Available at: [Accessed 15 April 2015]. Reichling, P., Spengler, T. and Vogt, D., 2005. A Note on the Value Additivity of Certainity Equivalents. [online] Available at: [Accessed 17 April 2015]. Read More