How the Nature of the Bankruptcy Code Affects the Capital Structure Decisions of Companies - Assignment Example

Question In what ways does the nature of the bankruptcy affect the capital structure decisions of companies? The Bankruptcy and capitalstructure decisions: The bankruptcy code has a strong influence in the capital structure decision of almost all the companies. Capital structure is the structure of capital. That means in what proportion the long term capital of a company is made up of by using debt capital and equity capital. Bankruptcy code is a set of strict guidelines for protecting the interest of creditors, when debtor is unable to pay its debts. (Commercial Litigation Terms). Though use of more debt capital in the capital structure has lot of advantages, it has got some disadvantages too. When a company is going to liquidation due to bankruptcy, it has to repay the debt capital first. The equity shareholders will be paid back their investment only after setting off the secured creditors, debenture holders, preference shareholders…etc. So the companies should deeply analyze financial implications before taking capital structure decisions. In United Kingdom, a secured creditor can even proceed with liquidating the company and claim the amount due to him by the company. Even though the cost of capital plays an important role while taking decision regarding the capital structure, the bankruptcy code also plays a prominent role in the decisions. Therefore, care must be taken while deciding capital structure. The companies cannot make changes in the bankruptcy code, but they can make adjustments in the debt-equity combination (capital structure) of their financial structures in order to accommodate bankruptcy code considerations. This assumes importance since the interests of equity holders would be compromised or endangered if debt capital is allowed to mount beyond reasonable proportions or as needed by the organisation. Increase in equity capital does not endanger the company’s existence or survival, however creditors and loan syndicates could call back their loans, or bring action for claim settlements, thus, putting the company at the doorsteps of bankruptcy. The UK bankruptcy code is a creditor-supportive and a debt-friendly code. That means the debt holders will be having right in deciding the liquidation of the companies. “If the cash flows generated by the project are insufficient to meet debt payments, the firm is in default. Continuation decisions in default are regulated by the bankruptcy code in place.” (Acharya, Sundaram and John, p.2). If a company is taking effective and efficient decision regarding the capital structure, it can easily overcome the problems which may arise due to unfavourable bankruptcy code. So while deciding on the capital structure, an optimum combination should be selected. While discussing the effect of bankruptcy code in the capital structure decision, the asset-specificity should also be considered. Asset-specificity can be defined as “aspect or feature of an asset (such as a specialized machine) that makes it useful for one or few specific purposes and which, therefore, cannot easily be sold off quickly in a fire-sale.” (Asset Specificity: Definition. 2009). If a company has low asset-specificity, it can use more debt capital in the capital structure. If the company is in a situation of liquidation or bankruptcy, it can easily sell off its assets and meet the debts like repayment of creditors, preference shareholders…etc. In other words, if the companies whose assets are fit for providing as security for funds borrowed, can use more debt capital in the capital structure. Because at the time of bankruptcy it will not face any difficulty in repaying the loan or borrowed money as it can sell off such assets. Whatever combination is used in the capital structure, the objective of the company should be to increase the wealth of the equity shareholders. If the bankruptcy code of a country is debt capital friendly, it is not better for the companies to follow ‘trading on equity’ (trading on equity refers to using more debt capital in the capital structure in order to give more returns to the equity shareholders.). One of the important points be noted is that, in order to say a capital structure is an ideal one, it must ensure maximum returns per share to the shareholders. Trading on equity has two advantages in the UK context. One is that, it gives maximum returns to the equity shareholders and increases the value of the companies. And the other benefit is that the bankruptcy code of the United Kingdom is debt capital friendly. A high capital structure can do well in the economies like UK where the bankruptcy code is favourable to those companies who are using more debt capital in their capital structure. Highly geared capital structure means, using more amount of fixed income bearing securities like preference shares, debentures…etc. than using the equity capital. If the debt capital is more in the capital structure, the risk borne by the equity shareholders is higher, because when there is any liquidation, the equity shareholders have to wait till the creditors, preference share holders, and debenture holders…etc are paid off. The financial leverage of a company is high means the company is using more fixed income bearing securities and it is paying more for that. When a company is not in a position to continue its business, not only the secured creditors make pressure for getting their money repaid, but also the other parties like, preference shareholders, debenture holders…etc. Therefore care must be taken to restrict the amount of secured creditors to some limit. Otherwise it may cause a situation of liquidation, or winding up of the company. Question 2: What are the implications of your answer for the trade off theory of capital structure? The trade-off theory of capital structure considers that firms trade off their cost of debt financing with higher interest rates and bankruptcy costs. The main debate that is triggered is with regard to the fact that firms would like to limit their use of debt capital in order to hold down the bankruptcy related costs. However, detractors of this theory hold that there are mainly three aspects of debt financing - debt, internal equity, and external equity and not just debt and equity considerations. Internal equity is considerably less costly than external equity from tax angle and even cheaper than debt. It is now necessary to understand when corporate would be willing to raise equity and when it would be skeptical to do so. If the company’s financial health is sound, it would not be inclined to go for equity investments since this would imply that future shareholders would now gain access to profits earned through the efforts of internal management; by investing in the shares of a prosperous company, new shareholders would become shareholders for future profits. In such cases, where the company has enough of reserves, it would decide that debt would not only bring tax benefits, but could also ensure that profits remain in the business. However, evidence based research does point out that a company which does not have much in terms of profits, or earned reserves would go in for equity issues, for simple reason that it would like future shareholders to share its losses. Thus the implications of buying and selling of shares imply that “issuing stock emits a negative signal and thus tends to depress the stock price.” It is therefore necessary that the company needs to maintain a good “reserve borrowing capacity” which could take care of good investment opportunist in future. (Brigham and Ehrhardt, p.647). However, this may not be applicable in all situations, and could only be seen as a general trade-off policy in that financial constraints for setting up new investments, production units and other considerations could precipitate an equity or public issue. Moreover, it is also seen that the tax advantages of internal equity over external equity could indicate that capital structure should function as internally generated cash flows. Tax effects control at low leverage, while distress costs dominate at high leverage. The firm has a most favourable, or target, debt ratio at which the increased value of tax shields from a small change in leverage precisely offsets the incremental distress costs. This notion of a target debt ratio, determined by firm characteristics like profitability and asset risk, is the central focus of many pragmatic tests. (Lewellen and Katharina 2006). It is seen that the trade off theory considers the cost of financial distress of a company. While debt capital does reduce tax burden, the fact that bankruptcy or financial distress could alter the debt: equity balance is beyond doubt or suspicion. The impact of impending bankruptcy could be envisaged in each of the following situations: 1. The company incurs heavy debts that it is obliged to pay off on demand or maturity. 2. In the event there is a call for extinguishment of debts, it is incumbent that this is met from resources, internal or otherwise of the company. 3. There could be a distinct possibility that the present financial situation does not allow the debts to be met, thus creating the debt holders to seek court intervention for settlement of their debts. 4. The costs could be of two types - indirect costs and direct costs. Indirect costs could be in terms of costs of realizing the debts, including debt holders and also cutbacks in certain kinds of costs, hoping to stem the flow of revenues or control costs. It is seen that management may resort to large scale downsizing in a bid to lower costs and attain efficiencies in revenues. 5. Direct costs could be in terms of out-of-pocket expenses in terms of liquidator’s costs and management costs for carrying out liquidation functions. “The trade-off theory of the capital structure posits that there is an optimal debt-equity ratio. Firms attempt to balance the tax benefits of higher leverage and the greater probability (and the possibly higher associated costs) of financial distress.” (Drobetz and Fix 2003, p.3). There are however certain major constraints in the use of trade off theories as they apply to bankruptcy that could be seen in the following arguments: 1. Most companies preserve accounting records on a going concern basis and not on basis of gone concern; thus, even if a stage arises that due to external pressures, funds paucity and management ineptitude, bankruptcy is very much evident, it becomes necessary to make major changes in the accounting systems to account for the matters concerning liquidation, with special reference to debtors’ dues, creditors’ dues, contracts taken up but unfinished, contingent liabilities, pending suits, taxation dues, etc. 2. All these need to be properly accounted and fixed in terms of a closing concern instead of a going concern, and prepayments, outstanding and total liabilities need to be accurately arrived at. 3. The trade off theory seems to suggest that management needs to incur outside debt till such time the marginal tax savings due to debt accretion is offset by the present derivative costs of future impending bankruptcy. Thus, it is seen that debts need to be incurred till such time it is overwhelmed by financial distress. 4. However, it is seen in many contexts, that large companies with large capital base still incur huge debt burden without the fear of bankruptcy, or even signs of financial distress. Thus, in such cases, the trade-off theory has limited applications. . “Trade-off theory would suggest that these same companies could achieve significant interest tax savings by increasing their debt ratios without any remote possibility of financial distress becoming an issue.” (RBA Keeps Interest Rates on Hold as Global Economy Collapses. 2009). It is now necessary to consider the fact that Trade-Off theory in the context of financial distress, or even bankruptcy proceedings cannot be assumed in all situations; it needs to be assessed on a case-to-case basis and the surrounding financial analysis and assessment needs to be made before a final verdict is delivered. Again, it is also seen that the factors of share overvaluation and undervaluation and their impact on debt equity ratios are also relevant. For one thing, it is seen that new equity issue, as mentioned earlier would be considered as a negative move by existing shareholders and there are possibilities that the share values may fall. However, once the issue is completed, the fears are allayed and the share prices rise again, thus many factors could possibly contribute to movement of share prices and impact on company’s future- as a going concern, or under liquidation. While most agencies believe that bankruptcy costs are not high, there is really much more in terms of material and opportunity costs in bankruptcy cases. “However, the cost of bankruptcy is sizeable in reality. The probability of bankruptcy is therefore, a function of a companys leverage ratio. Therefore, costs in terms of legal and administrational costs, however, there are also liquidation costs of below market value sells of fixed assets.” (Free Essays Finance Essays. 2009). Conclusions: The matter of financial distress or bankruptcy does assume significance, especially in companies which do not have robust fiscal discipline and judicial use of financial assets, including check and control mechanisms. While the impact of bankruptcy on capital structure is company specific, there is also need for pre-assessing and identifying the potential dangers of having a highly geared capital structure, while considering the management‘s decisions for going in for fresh debts, mopping up internal resources or seeking financial succour from external debt sources in order to provide investment funds or asset acquisition plans for the company in both the short and medium terms. While a lot would depend upon the characteristics of each company sourcing and the credibility of the management, a lot would also depend upon the extent of impact of capital structuring on debt equity parity. Bibliography Acharya, Viral V., Sundaram, Rangarajan K., and John, Kose. On the Capital Structure Implications of Bankruptcy Codes: The Theoretical Model. [online]. Last accessed 16 March 2009 at: http://www.afajof.org/pdfs/2005program/UPDF/P444_Corporate_Finance.pdf Asset Specificity: Definition. (2009). [online]. Business Dictionary.com. Last accessed 16 March 2009 at: http://www.businessdictionary.com/definition/asset-specificity.html BRIGHAM, Eugene F., and EHRHARDT, Michael C. Financial Management: Theory and Practice: Trade-Off Theory. 10th edition. P. 647: Commercial Litigation Terms. [online]. Curtis and Arata: A Professional Law Corporation. Last accessed 16 March 2009 at: http://curtisandarata.com/commercial_terms.html DROBETZ, Wolfgang., and Fix, Roger. (2003). The Trade off Theory. [online]. UNiBASEL P.3. Last accessed 16 March 2009 at: http://pages.unibas.ch/wwz/finanz/publications/researchpapers/4-03%20CStructure.pdf Free Essays Finance Essays. (2009). [online]. 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