Fundamentals Of Corporate Finance - Case Study Example

 Fundamentals Of Corporate Finance Introduction The search for an optimal capital structure is based on the need to create value for the shareholders. Different types of companies under different circumstances will face unique problems of their own when it comes to obtaining financing that will impact their capital structures directly and the firm's earning power indirectly. This paper seeks to explore the ways in which capital structure is determined and how to obtain financing for growth or expansion. a. The Modigliani-Miller Models In 1958, two prominent financial economists, Franco Modigliani and Merton Miller, developed and published a theory of capital structure, the Modigliani-Miller Model (usually referred to as the MM), widely acknowledged as the most significant and influential financial theory up to the present. Both writers won the Nobel Prize in economics for their contribution, which has spawned numerous other research efforts. Basically, the MM theory assumes perfect capital market conditions: all relevant information is readily available, transaction costs are nonexistent, and borrowing and lending rates are the same for all investors. The theory further assumes no income taxes, with operating income remaining constant over time, and all earnings being paid out as dividends. The theory arrives at the conclusion that capital structure does not matter because the cost of capital remains unchanged. Keat and Mathis (2003), paraphrasing the authors, enumerate the following reasons: 1. The risk-free interest is constant. 2. The cost of debt is always lower than that of equity because equity is more risky. 3. As the debt/equity ratio increases, the cost of equity capital will rise because stockholders will incur more risk. 4. The weighted cost of capital remains the same because the increased cost of equity capital is exactly offset by the increased weight of the lower-cost debt in the capital structure. Five years later, Modigliani and Miller modified the assumptions of their model by adding corporate taxes. With that modification, the use of leverage (gearing) would increase the firm's value, and it would be reflected in the market price of its shares because interest on debt is tax deductible. Net income and retained earnings would increase. The cost of debt is reduced because of the tax shield. For example, if the debt interest is 10 percent, the net expense would be 6.5 per cent, assuming a corporate income tax rate of 35 percent. Thus, combined with the cost of equity, the tax shield would effectively lower the weighted average cost of capital (WACC). This circumstance can lead one to conclude that more and more debt is sound from the profitability point of view, even to the extent of 100 per cent debt. In reality, however, firms do not carry the logic that far and opt to target a certain appropriate mix of debt and equity. While historically the debt-to-asset ratios of companies in the United States have risen, companies still target a combination of debt and equity (See Brigham and Gapenski 1997). Years later, Merton Miller would advance a new addition to the theory by including personal taxes. Personal taxes, because they affect investors total disposable income, influence their view of a company's value. It would thus reduce the benefits of debt financing. b. The Traditional View. Before the MM theory came to the fore, business schools had always taught that a certain degree of leverage could enhance a company's profit picture. Where there existed spare borrowing capacity as measured by the low ratio of debt to equity (e.g., .25:1), a firm's management could be under pressure from the stockholders to borrow for its additional fund requirements if an investment opportunity presented itself or an expansion in existing operations was needed, particularly if the current cost of debt capital was significantly lower than the desired rate of return on equity. Another consideration was the fact that a company with so much liquidity could be a takeover target. Under the traditional view, if a growth opportunity is being contemplated, the firm estimates the net present value of all cash flows provided it does not differ from the firm's own business risk. Debt financing would improve the net present value of a project assuming a certain opportunity cost of capital, compared to pure equity financing. The traditional view has been refuted by the MM model because the latter argues that the added debt will cause the required rate of return to adjust upwards, so that in actuality the the value of the firm or its stock does not rise. Maintaining the traditional view implies insensitivity to that risk. Being a model, the MM leaves out many variables such as the the quality of management and an industry's vulnerability –- or lack thereof -- to cyclical movements and to unique as well as systemic risks. For example, the historically high leverage ratios of General Electric can cause alarm to one who does not know the company's size, quality of management, and stable earnings performance through the years. From the practical point of view, most companies would argue that there is validity to the use of an appropriate mix of debt and equity, Keat and Mathis (2003) have constructed a chart that demonstrates how the debt/asset ratio interacts with the WACC to find a level where the weighted average cost of capital is at its lowest. Fig. 1 Note that in Fig. 2, with the WACC at the minimum, the market value of the firm is at its maximum. When the debt/asset ratio is increased further, the cost of capital will also increase and the market value of the firm may start to decline. Fig.2 c. The Trade-Off theory This brings us to the Trade-Off Theory, which asserts that the marginal cost and benefits are balanced against one another, yielding an optimal capital structure that would lie somewhere between zero and 100 percent debt. An optimal debt ratio is one which reflects a trade-off between the tax shields advantage and the costs of financial distress. Financial distress can result when a company continues to borrow, causing the risk to increase progressively. Borrowing to take advantage of the tax deductibility of interest may cause lenders to require higher interest rates to such an extent that the firm can no longer use debt The increase in borrowing costs will begin to offset the advantages of the tax deductibility of interest. Companies with substantial tangible assets usually can borrow with less risk than high-growth, particularly technology, companies whose asset values have a large intangibles component. Financial distress occurs when the firm cannot meet its obligations to the creditors. It can lead to a loss in value of the business, affecting both its stocks and bonds. The value of the firm may be described as the sum of the its value under the assumption of fully equity-financed and the present value of the tax shield, less the present value of the costs of financial distress (See Brealey and Myers 1999). Included among financial distress conditions are the bankruptcy costs (costs involved in creditors being allowed to take over the assets of the company and controlling the business), the cost of operating the business under bankruptcy, and agency costs . Other financial distress costs are the difficulty of hiring able people and getting the support of suppliers. The market price of the company's shares fall, ad development that is adverse to existing investors. When a non-bankrupt financially troubled firm creates conflicts of interest between shareholders and creditors, agency costs are incurred. In searching for ways to cope with the situation, shareholders may "play games” that can hurt lenders, such as investing in risky negative-NPV projects, refusing to contribute additional equity, issuing more and riskier debt, among others. Lenders may counteract these shareholder tactics prospectively by using strict conditions in debt contracts, thereby reducing shareholder flexibility and adding to the costs. d. The pecking Order Theory Many companies use a preferred order of financing choices. This is done by using internal equity or retained earnings (and depreciation) first, followed by debt, and finally , as a final resort, new common stock. Brigham and Gapenski (1993) also call this the asymmetric information theory, which assumes that managers have better information than investors. When financial managers fail to follow this sequence of obtaining financing, the results can be disconcerting. For example, if new common stock is raised the market usually reacts by discounting the price because the company “knows” that the shares are overvalued. Hence the issuance of new common shares is usually the last resort. At the same time, the theory posits that managers tend to maintain a financial slack, or flexibility of means in order to meet future financing needs. Funds may be held in the form of marketable securities and spare borrowing capacity, such as a bank overdraft line or leasing arrangements (Cornell & Shapiro 1993). A survey of capital structure practices. To learn the practices of companies and industries regarding capital structure policies, in 1995 the Compustat Industrial Data Tape (cited in Brigham and Gapenski 1997) compiled the results of survey of the financial leverage of U.S. companies both across industries and among firms within each industry. Table 1 shows part of the results. Table 1 Capital Structure Percentages Four Industries Ranked by Common Equity Ratio Industry Common equity Preferred stock Total debt Long-term Debt Short-term Debt Return on equity Drugs 74.40% 0.00% 25.60% 18.70% 6.9 26.40% Electronics 68.40 .00 31.60 24.50 7.10 11.70 Retailing 53.60 1.00 45.40 39.40 6.00 16.20 Utilities 46.90 5.30 47.80 43.80 4.00 5.60 Composite (average of all industries) 37.70 1.50 60.80 38.70 22.10 11.70 Note that drugs and electronic companies used relatively little debt relative to equity, owing mainly to substantial expenditures in research Utilities had average debt ratios, while retailing normally used debt for inventory purposes; its long-term debt as a ratio to common equity is less than 1. The variations among firms within the industry are wide. For example, in the case of the drug industry , Bristol-Myers Squibb had 11 percent debt while Warner-Lambert had 46 percent. They conclude that "factors unique to individual firms, including managerial attitudes, play an important role in setting target capital structures." (Brigham and Gapenski 1993). These data the above are not helpful in forming judgments about industry-specific characteristics of capital structures. Sample of US companies We conducted an analysis of the capital structures of four US-listed companies – consisting of two utility companies and two technology companies, using 5-year historical balance sheet data. The main constraint facing a more comprehensive study is the lack of time. The reason for choosing only these two types of companies is that utilities are known to be generally stable and conservative and technology companies are characterized by high growth and hunger for cash. The presumption was that utilities would have target capital structures that vary little, while technology companies would have a low debt/equity ratio because of their difficulty in getting debt financing. a. Utilities 1. Energen Corporation (EGN) Balance Sheet item, in $ million 2008 2007 2006 2005 2004 Total assets 3,775.4 3,079.65 2,836.89 2,618.23 2,181.74 Intangible assets 0 0 0 0 0 Net tangible assets 3775.4 3079.65 2836.89 2618.23 2181.74 Total liabilities 1,862.11 1,701.0 1,634.82 1,725.55 1,378.07 Current liabilities 510.1 606.23 560.88 688.31 498.62 Long-term debt 570.45 609.46 582.49 683.24 612.89 Stockholders equity 1,913.29 1,378.66 1,202.07 892.68 803.67 Debt/Assets 0.49 0.55 0.58 0.66 0.63 Capitalization (LTD+ Equity) 2483.74 1988.12 1784.56 1575.92 1416.56 LTD/Capitalization 0.23 0.31 0.33 0.43 0.43 Debt/Equity 0.97 1.23 1.36 1.93 1.71 (Source of raw data: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=EGN&lstStatement=Balance&stmtView=Ann) The leverage ratios of Energen Corporation show a tendency to use debt financing. During the last 5 years current liabilities and long-term debt have been nearly equal in size, resulting in above-average debt/equity ratios. The capitalization ratio is about one-third, falling to .23 in 2008 as long-term debt dropped while stockholders equity rose. The optimal debt/asset ratio seems to be between .50 and .60, and it would be interesting to see if this is the level that the company intends to maintain in the future. 2. PPL Corp.(PPL ) Balance Sheet item, in $ million 2008 2007 2006 2005 2004 Total assets 21,405.0 19,972.0 19,747.0 17,926.0 17,733.0 Intangible assets 1359 1326 1521 1486 1463 Net tangible assets 20046 18646 18226 16440 16270 Total liabilities 16,328.0 14,416.0 14,625.0 13,508.0 13,443.0 Current liabilities 4,293.0 2,882.0 3,348.0 3,354.0 2,295.0 Long-term debt 7,452.0 7,191.0 7,029.0 6,095.0 6,881.0 Stockholders equity 5,077.0 5,556.0 5,122.0 4,418.0 4,290.0 Debt/Assets 0.76 0.72 0.74 0.75 0.76 Capitalization (LTD+ Equity) 12529 12747 12151 10513 11171 LTD/Capitalization 0.59 0.56 0.58 0.58 0.62 Debt/Equity 3.22 2.59 3.06 3.06 3.13 (Source of raw data: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=PPL&lstStatement=Balance&stmtView=Ann) The second utility company, PPL Corporation, is highly leveraged. The debt to assets ratio is consistently above .70. Long-term debt exceeds equity in its total capitalization. Only a utility company with a solid record of cash flows remain healthy with this leverage level without teetering on the brink of financial distress. b. Technology companies. 1. SanDisk Corporation (SNDK) Balance Sheet item, in $ million 2008 2007 2006 2005 2004 Total assets 5,926.94 7,234.82 6,967.78 3,120.19 2,320.18 Intangible assets 63.18 1162.89 1299.33 10.03 0 Net tangible assets 5232.82 6071.93 5668.45 3110.16 2,320.18 Total liabilities 2,752.14 2,275.2 2,199.65 596.4 380.03 Current liabilities 1,263.01 913.88 896.45 571.14 353.45 Long-term debt 1,225.0 1,225.0 1,225.0 0 0 Stockholders equity 3,174.8 4,959.62 4,768.13 2,523.79 1,940.15 Debt/Assets 0.46 0.31 0.32 0.19 0.16 Capitalization (LTD+ Equity) 4399.8 5993 5993.62 2523.79 1940.15 LTD/Capitalization 0.28 0.2 0.2 Inf Inf Debt/Equity 0.87 0.46 0.46 0.24 0.2 (Source of data: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=SNDK&lstStatement=Balance&stmtView=Ann) It is remarkable that SanDisk Corporation has a low proportion of long-term debt in its capitalization, all below .30 during the past 5 years. The debt/assets has been low throughout the past 5 years, and the debt/equity ratio is quite low except in 2008. A small technology company faces credibility when tapping the debt market. For better viability, it needs lots of cash from the stockholders. 2.Novatel Wireless, Inc. (NASDAQ:NVTL) Balance Sheet item, in $ million 2008 2007 2006 2005 2004 Total assets 260.73 296.63 191.65 176.06 116.32 Intangible assets 1.86 1.54 2.41 3.46 4.62 Net tangible assets 258.87 295.09 189.24 172.6 111.7 Total liabilities 62.77 78.88 57.41 55.01 16.15 Current liabilities 43.85 63.32 55.72 55.01 16.15 Long-term debt 0.27 0.36 0 0 0 Stockholders equity 197.96 217.75 134.24 121.06 100.18 Debt/Assets 0.24 0.27 0.3 0.31 0.14 Capitalization (LTD+ Equity) 198.1 218.12 134.24 121.06 100.18 LTD/Capitalization - - - - - Debt/Equity 0.32 0.36 0.43 0.45 0.16 (Source of data: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=nvtl&lstStatement=Balance&stmtView=Ann) Long-term debt for Novatel is almost non-existent so that its capitalization is composed almost completely of equity. The debt/assets ratio is very low, indicating huge borrowing capacity. However, most of its debt is in the form of current liabilities. The company is probably too cautious about borrowing, but it is also possible that no growth options have yet come. Provided it can convince lenders, it has a big potential to avail itself of the debt market. Out hypothesis has been verified to some extent. Utilities, because of their normally steady cash flows, are able to tap the debt market without much fear of financial distress. They normally have high debt ratios and use long-term debt often to finance expansion or a new growth opportunity. Technology companies, some of which are experiencing above-average growth, have low leverage ratios, partly because they lack credibility and partly because they have ample cash to begin with. Trade-Off Theory vs. Pecking-Order Theory: A UK study A survey of the financing decisions of UK-listed companies was conducted several years ago by Beattie et al (2006). The survey attempted to determine whether the companies surveyed used the trade-off theory or the pecking order theory when they made financing decisions. It had been assumed that pecking order theory and trade off theory are competing descriptors of company practice or that they were mutually exclusive. It was found out, however, that 32 percent of the respondents followed both theories while 22 percent followed neither. Sixty percent followed a hierarchy (pecking order) while 50 percent followed a target capital structure (trade off). The conclusion was that “firms seem to use an eclectic approach when considering financing alternatives.” The answers given by finance directors of the UK listed companies were not fully consistent with either of the main theories. The researchers attributed this finding to 'bounded rationality' : The capital structure decision is complex and multi-dimensional, that there are complex group processes that still have to be grasped. Our conclusion is that there are too many variables that impact capital structure decisions. Finance officers , whether they are conscious of these two theories or not, use a host of criteria in determining capital structure choices. Raising investment funds There is a wealth of ideas about the financing options of companies. The following are our condensed ideas derived from finance textbooks, the works of Cornell and Shapiro (1993) and Stewart Myers (1993), and other resources. A high-growth company in any industry would normally find it difficult to obtain financing for its project compared to companies that are stable, mature, and showing stable cash flows in the past several years. While companies of the latter category have tangible assets, high-growth companies usually have a disproportionate amount of their assets in the form of intangibles. Thus when they encounter cash-flow problems approaching financial distress, the intangibles are the first to go, and the remaining tangible assets may not be adequate to meet the creditors' demands. A growth company is going to face serious financial difficulties if it is not equipped with substantial amount of equity and cash right from the start. It therefore pays to be armed with substantial amounts of cash, even if raising it involves deep discounts. This is because later on it has little credibility to tap the debt market, obtain bank financing, or float new shares in the market. Also, with enough financial strength from the very beginning, it is able to obtain the commitment of its suppliers and other stakeholders in order to develop a relationship that can assure its continued existence and ability to take advantage of investment and growth opportunities. In the event that it has to go to the debt market, a relatively new company can consider tapping banks. Commercial banks provide short-term capital, but loans can be rolled over. In some countries there are development banks that provide financing beyond a period of one year. Loan terms are flexible and negotiable. The monitoring of the progress of the investment by the bank officer, the consultation sessions and advice, and the rescheduling, as necessary, of the loan repayments are certainly convenient in the banking relationship. An alternative is to seek venture capital. Venture capitalists provide equity, but in return they demand control and expect higher returns. They also require that management display commitment by putting up their own funds, by receiving modest compensation, and by linking incentives to results. Venture capitalists usually contribute capital in the form of convertible preferred stock because it gives them prior claim on the company's assets and at the same it gives them the opportunity to become shareholders when the company performs well. Venture capitalists do not provide all the funds at once but do so by stages – that is, after every milestone. In this way, they would be able to cut their losses when things do not pan out. They would provide more capital when things turn out as planned. A third alternative financing source is private placement. Compared to bank loans, which can charge relatively high interest rates, and venture capitalists, who often impose burdensome conditions and controls, private placements can be cheaper and the terms of the placement can be negotiated. This arrangement involves close monitoring, quite similar to the venture capitalists arrangement. Conclusion Each firm must find a capital structure that fits its specific circumstances. A scanning of the environment should provide management with the information whether opportunities are present and an internal appraisal should yield information on what financing options are feasible. Big, stable companies with good cash flow track record normally don't have difficulty obtaining financing. Companies with high market-to-book value ratios are priced high by the market because of the promise of high long-term earning power, and they can tap the equity market if they want to. During the credit crisis, the pervasive reluctance of banks would close out the option of bank financing. The general pessimism that is pervasive during a recession would affect all companies in both the debt and equity markets. It is more likely that each financing proposal would have to be evaluated on its merits before funds can be obtained. Different modes of financing can affect the way a business is run. This is particularly true in the case of venture capital and private placement. BIBLIOGRAPHY Beattie, V. and Goodacre, A. and Thomson, S.J. (2006) Corporate financing decisions: UK survey evidence. Journal of Business Finance and Accounting 33(9-10):pp. 1402-1434. Viewed December 16, 2009 at http://eprints.gla.ac.uk/3336/ Brealey, RA, Myers, SC & Marcus, AJ, 1995, Fundamentals of Corporate Finance, McGraw-Hill, Boston, Mass Brigham EF & Gapenski, LC 1996, Intermediate financial management, 5th edn., The Dryden Press, Orlando, FL Cornell, B & Shapiro, AC 1993 "Financing corporate growth" in Chew Jr, The new corporate finance, Prentice Hall, New York. Keat, PG & Mathis, FJ 2003, Financial Management. Simon & Schuster, New York Financial statements, Moneycentral. Viewed December 16, 2009 Source of raw data: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx Myers, S 1993 The search for optimal capital structure" in Chew Jr, The new corporate finance, Prentice Hall, New York. Read More