Capital Funding Structure - Case Study Example

Capital Funding Structure Table of Contents Managing capital structure 2 Capital structure theories 3 Maximization of shareholders wealth 6 Analysis of capital structure of Hallin Marine Subsea Intl and peer companies 8 Recommendation for effective capital structure 10 References 12 Introduction The financial structure is linked with the market conduct by theoretical literature emphasizing the strategic use of leverage. Any change in capital structure significantly impacts the pricing and entry and exit of market participants. The firm can use its capital structure to influence the behaviour of its competitors, suppliers and customers. A highly reputed firm can take the advantage of its powerful position to command favourable deal from the suppliers. (Matsa, 2006). Capital is a strategic tool influencing the long term growth prospects of the company. It has to be efficiently managed on account of its impact on the shareholder value. The goal of a company must be to strike an optimal balance between the various sources of funding. Undue reliance on any one source can be detrimental for the financial health of the company. Managing capital structure The primary aim of a company is to employ the capital in a way that the return generated from the investment can be greater than the cost of acquiring it. In other words, the Return on invested capital (ROIC) must exceed the Weighted average cost of capital (WACC). The higher the ROIC, the more is the value generated by the company. The efficient management of available resources maximizes the value of the company. Every company must thrive towards achieving an optimal capital structure as it improves the efficiency of the employed capital (Putrajaya Committee on GLC High Performance, n.d.). Source: (Putrajaya Committee on GLC High Performance, n.d.). An optimal capital base helps the companies to strengthen the growth prospects of the company by seizing the opportunities. This helps the company in acquiring a competitive position in the market. In designing an optimal capital structure the company has to decide upon the right mix of debt and equity. For this the company has to follow a four step process. Step 1- Financial forecasting The company has to make an accurate forecast of the determinants of the cash flow, analyse the possibility of any variations and risks. This can be done by independent functional groups. Step 2- Ideal financial ratios The financial ratios like the debt/equity ratio and the interest coverage ratio can act as good determinants for achieving an ideal capital structure. Step 3-Testing the capital structure The target capital structure must be tested with the financial ratios against different possible scenarios. Step 4- Taking action for implementing ideal capital structure Suitable actions must be taken for adjusting the capital structure with the desired ratio. Capital structure theories The choice of capital structure is based on two important theories. The trade-off theory which states that the companies with an ideal debt-equity ratio determine this level by making a trade-off of the advantages of debt financing over its costs. This model views the interest tax shield as the main advantage of using debt. This theory highlights the weights of the debt finance and equity finance used by the company to balance the respective benefits and costs. It explains that that the tax advantage of debt comes at a cost. These costs being the financial distress like the bankruptcy costs as well as the non-bankruptcy costs that include the unfavourable demands of the suppliers. This theory advocates the use of higher debts for matured companies with cash flow stability for getting higher tax benefits. On the other hand the smaller companies, vulnerable to financial distress, must make a limited use of this source of financing. The Pecking-order theory is often said to be a competitor of the trade-off theory. This theory states that the companies use equity as the last resort and debt gets a preference over equity in the event of external financing. It is the practice of the corporate to use the internal mode of financing and issuing debt instead of equity in case of further requirements. The equity mode of financing is considered to be very expensive. The theory is of the view that the managers avoid issuing equity particularly when its shares are undervalued by the market. Even if the shares are fairly valued the decision to issue fresh equity causes the share prices to fall below its fair value. The issue of new equity is interpreted as a sign of overvaluation by the market and hence the stock price falls. As per the Financial Leverage theory the optimisation of debt ratio is not possible. Hence, the Earning per Share and risk increases with the rise in debt. The M & M theory views the markets to be perfect and states that the capital structure does not influence the value of a firm. The choice of debt depends on various factors. Source: (Graham, Harvey, 2002). The above figure suggests that the tax advantage of using debt is moderately important in decisions relating to capital structure. Nearly 45 percent of the companies describe it as very important or important. The debt policy of the company is governed mainly by the ‘financial flexibility’ that the company wants to preserve. By doing this they try to preserve their unused debt limit. They maintain this excess capacity for funding future expansion plans. This also helps them in maintaining a desired credit rating as the rating is important for large sized companies. Moreover the volatility in the earnings also influences debt decisions (Graham, Harvey, 2002; Svendsen, 2003). Maximization of shareholders wealth The Corporate Finance theory revolves around the maximization of the value of the company to its shareholders. Capital Budgeting decisions have a significant impact on a firm’s value and the shareholders wealth (Dayananda, 2002). The firm’s objective of maximising value can be achieved by minimising the cost of procuring capital. Beyond a point a rise in the debt ratio is accompanied by a rise in required return on equity. The rise in the required return of equity is initially moderate. When the debt ratio becomes very high to the extent of endangering a firm’s solvency the shareholders demand higher returns (Roger, Sherry, 2000). Capital structure theory highlights the significance of debt/equity ratio in maximising a firm’s value. The findings of Berger and Patti (2006) reveal that low equity ratio is related to higher performance. Various other researchers like Fama & French (2002) Leland (1994) have highlighted a positive link between leverage and profitability (Hassan, 2009). An ideal mix of debt and equity ensures that the company is making good use of the lucrative opportunities in generating higher earnings for the shareholders. At various stages of the business cycle the company may come across investment opportunities that can raise its earnings potential and this can result in value creation for the shareholders. It is important that the company seizes this opportunity to maximise its profitability. For this, the company can adopt either a debt or equity route. The decision in this regard will be based on several factors. If the company has surplus debt capacity then it can raise money by issuing long term bonds. But, the cost of obtaining debt will depend upon its fundamentals. A company with strong credentials can get credit on favourable terms from the market. On account of its strong fundamentals, the company can bargain for reasonable credit terms. But here again the company has to keep in mind that undue reliance on debt can expose it to unnecessary financial burdens. If the debt ratio in the company’s capital structure goes beyond permissible levels the investors view it as a risky proposition. A conflict arises between the debt holders and the shareholders. The debt holders try to influence the decision making in the company matters. This undermines the importance of the shareholders who are the real owners of the company as they are the ones who had taken the risk and floated the company by providing capital. The suppliers become cautious in extending credit to a risky business. Considering the risk, they demand higher interests. Since, most of the company’s earnings are used in honouring its financial obligations it has very little left for the shareholders. As most of the company’s earnings are used in financing its obligations it cannot plan for any expansion. The growth of the company gets adversely affected making it unattractive to the investors. All this goes against the basic premise of shareholders wealth maximisation. Hence, it is very important that the company plans its financing decisions keeping the shareholders interest in mind. The company should employ judicious levels of debt as any overdependence on this source can lead to bankruptcy and other liquidity related problems. For financing its expansion plans the company must use its internal sources like retained earnings as it will not burden it financially. In the case of any additional requirements, it can use debt. If the credit rating of the company, which is an indicator of company’s solvency, is good it can get loans on favourable terms. This rating in turn is a measure of the company’s fundamentals like debt/equity ratio. It is the responsibility of the management to keep the shareholders interest in mind while planning its operations. This does not mean that the company must not take risks but not at the cost of the shareholders interest. All the decisions of the company must be based on this motive. The management must work towards achieving an optimal capital structure so that the company neither loses on the investment opportunities nor does it burden itself to the extent of threatening its solvency. Analysis of capital structure of Hallin Marine Subsea Intl and peer companies About the company- Halin Marine Subsea Intl is primarily engaged in off-shore intervention in the sub-sea for telecommunication, oil and gas. With market cap of $52.79m it ranks third among its peers. The competitors of Hallin Marine Subsea Intl include Corac Group, Kentz Corporation, Lupus Capital etc. The company has increased the debt component in its capital base over the years as is evident from the rising debt/equity ratio over the years. This has helped the company in increasing its revenue along with the rise in net income. The cash flow of the company which dipped to its lowest levels in 2005 and 2006 has improved considerably in the last two years. The company’s debt/equity ratio for the year 2008 stands at 0.509. This is well within the permissible limits. It means that the company is putting an equal weight on debt as well as equity. The debt/capital ratio of the company is 0.337. This means that the company’s debt is nearly 33 percent of its capital outlay. The interest coverage ratio of the company is 16.05. This indicates that the company is capable of paying 16 times its current interest expenses. All these are fairly good signs and are an indicative of the optimal use of capital structure. Neither is the company overexposed to debt, nor is its earnings affected by scarcity of capital. The company has succeeded in striking a right mix between the equity and debt component of capital base. It has successfully exploited the available opportunities as evident from the gross profit and net profit margins of the company (Financial Times, 2009).The gross margin of the company has increased to 32.95 percent in 2008 along with a net profit margin of 20.34 percent in the same year. This has risen over the years (Financial Times, 2009). The company has nearly doubled its total debt in comparison to the last year. The equity component has also doubled over the same period. It has risen from $33 million in the last year to $63 million in 2008 (Financial Times, 2009). Despite the rise in debt, the company has maintained the interest of the shareholders as evident from the rise in the Basic Normalised EPS from $0.18 to $0.60 in 2008 (Financial Times, 2009). Corac Group, an important competitor, of Halin Marine Subsea Intl is not exposed to financial risk, as it does not rely on leverage. As a result of this the company is not able to make any positive contribution to the shareholders wealth. The company’s financials exhibit a negative net profit margin which stands at -448.34 percent in 2008. This has adversely impacted the return on equity which is also in the negative territory (Financial Times, 2009).The company’s long term debt stands at zero. The company has failed to make any positive contribution in value creation. Its losses have been rising over the years. All these indicate a fallacy in its capital structure which is retarding its growth. Lupus Capital, another among the peer group, has a debt/equity ratio of 0.70 and its debt/capital ratio is 0.41. Both the ratios indicate the company’s undue reliance on debt financing. This is not good for the financial health of the company as it is a financial burden (Financial Times, 2009) The interest coverage ratio of the company is 1.03. This means that the company is just able to meet its financial obligations. Any kind of volatility in the earnings can result in serious liquidity problems for the company (Financial Times, 2009). Despite the rise in revenue the company’s net income has not increased significantly. This can be due to the enormous financial obligations that the company is burdened with. As a result of this the company has not been able to create any value for its shareholders. Kentz Corporation has an insignificant amount of debt in its capital base. Its debt/equity ratio is 0.037 and the debt/capital ratio is 0.035 (Financial Times, 2009).The company has reduced its long term debt component from $0.117 million in 2007 to $ 0.030 million in 2008 whereas the equity component of the company has nearly doubled from the last year (Financial Times, 2009). So, the company is primarily relying on the equity mode of financing to fund its operations. Despite the rise in equity the company’s EPS has not been diluted. This is because the company’s revenue has risen over the last year. The company is efficiently managing its equity resources such that it is able to tap the growth prospects without exposing itself to financial obligations. Recommendation for effective capital structure Of the various marine companies analysed above, the capital structure of Halin Marine Subsea Intl is the most ideal one. The company has managed to strike a trade-off between the debt and equity as a result of which the company is not just able to utilize the opportunities but has remained attractive for the investors. The net income of the company stands at $17.15 m which is the second highest among its peers. Kentz Corporation on the other hand reported a net profit of $17.48m in 2008. It is exposed to a very insignificant amount of debt and has successfully managed its equity resources in generating revenue of $3.36 per share. But this has diluted its EPS (including extraordinary items) which stands at $0.15 in comparison to $0.38 of Halin Marine Subsea Intl (Financial Times, 2009). Corac Group on the other hand has not been able to achieve an optimal capital base as a result of which it has failed to fulfil the objectives of the shareholders. It is recommended that it increases its exposure to debt financing to an optimal level such that it becomes successful in generating a positive return for its shareholders. Thus, it can be seen that some amount of debt in the total capital outlay is important. But it is important to maintain it an ideal level. The heavy debt exposure of Lupus Capital has resulted in a negative EPS for its shareholders. So it is recommended that both Lupus Capital and Corac Group make an adjustment in their debt structure. While the former should try and reduce its debt exposure and the latter should increase its debt exposure. References Matsa, D. 2006. Capital Structure as a Strategic Variable:Evidence from Collective Bargaining. Available at: http://www.gsb.stanford.edu/facseminars/pdfs/matsa-capitalstructure.pdf [Accessed on November 14, 2009]. Putrajaya Committee on GLC High Performance. No Date. How To Optimise The Capital Structure. Available at: http://www.pcg.gov.my/PDF/purple_content.pdf [Accessed on November 14, 2009]. Graham, J. Harvey, C. 2002. How do CFOs make Capital budgeting And capital structure Decisions?. Duke University. Available at: http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdf [Accessed on November 14, 2009]. Svendsen, S. 2003. The debt ratio and risk. International Farm Management Congress 2003. Available at: http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdf [Accessed on November 14, 2009]. Dayananda, D. Capital budgeting: financial appraisal of investment projects. Cambridge University Press:2002. Morin, R. Jarrell, S. Driving shareholder value: value-building techniques for creating shareholder wealth. McGraw-Hill Professional: 2000. Hassan, H. 2009. The relationship between corporate governance monitoring mechanism, Capital structure and firm value. Available at: http://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2009-milan/phd/hassan.pdf [Accessed on November 14, 2009]. Financial Times, 2009. Company Description. Available at: http://markets.ft.com/tearsheets/businessProfile.asp?s=HMS%3ALSE [Accessed on November 14, 2009]. Financial Times. 2009. Financials. Available at: http://markets.ft.com/tearsheets/financialsSummary.asp?s=HMS%3ALSE [Accessed on November 14, 2009]. Financial Times. 2009. Balance Sheet. Financials. Available at: http://markets.ft.com/tearsheets/financials.asp?type=bs [Accessed on November 14, 2009]. Financial Times. 2009. Income Statement. Financials. Available at: http://markets.ft.com/tearsheets/financials.asp?symbol=HMS:LSE&type=is [Accessed on November 14, 2009]. Financial Times. 2009. Financials. Corac Group. Available at: http://markets.ft.com/tearsheets/financialsSummary.asp?s=UK%3ACRA [Accessed on November 14, 2009]. Financial Times. 2009. Financials. Lupus Capital. 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