A Survey of the Financing Decisions of UK: the Trade-Off Theory or the Pecking Order Theory - Research Paper Example

 Introduction Long- term finance may be described as business finance with a maturity of one year up to 30 years or even more (Long term). For the purpose of this paper, all funds that are held for for such length of time the purpose of acquiring assets for the business and which appear as either long-term debt or equity will be considered long term finance. At the outset, every start-up business has to rely on equity to be able to establish and sustain its business for at least the first few year before tapping the debt market. This is necessarily so because the company has yet to establish an earnings record, a precondition for gaining credibility with the creditors. Once the business becomes viable, the challenges shift from where to get financing for expansion or for increasing working capital to one of the mix between debt and equity. Under normal economic conditions, a large firm like AIG would have to make a decision as to what combination of debt (short term and long term) would be ideal for helping maximise shareholder value. This paper shall discuss the issue of long-term finance from the viewpoint of a large firm. The American International Group, Inc. (AIG) has been chosen as the company to study as regards long-term financing strategy. The Company American International Group, Inc. (AIG) is a holding company that engages in insurance and insurance-related activities. The latter include property, casualty, life insurance; but also financial services, retirement savings products, asset management, and aircraft leasing. The firm is one of the world's largest insurance companies. It belongs the financial sector and the property and casualty insurance industry. It is listed in the Nyse and the stock exchanges in Tokyo and Ireland. In 2008 and 2009 AIG suffered huge losses, compelling the U.S to initiate a bailout program. Despite this economic adversity, the firm and its subsidiaries continue to provide normal business services to its clientele worldwide. . Because of the $182 billion government bailout money, the US government now owns more than 80% of the company. The firm is in the process of selling assets to repay its debts to the state. The crisis came about because the valuation of the credit default swaps it sold declined 2007 as the U.S residential mortgage market began to deteriorate. Huge unrealised market valuation losses led to sisable cash outflows. Out of $96 billion in revenues in 2009, the company suffered a net loss of $11.7 million, representing a net loss margin of 12.3 per cent, Return on equity was -183.5 percent owing to reduced equity base. No dividends were paid during 2009. The Modigliani-Miller Theory To better understand company policies and practices regarding financing with debt or equity, one needs to understand some relevant theories. The most influential theory of long-term finance and capital structure in recent times was formulated in 1958 by Franco Modigliani and Merton Miller, both financial economists. The Modigliani-Miller model (otherwise referred to as the MM) assumes perfect capital market conditions whereby all relevant information are accessible to all, transaction cost are non-existent, and all lending rates are the same for all. Further, the model assumes that no income taxes are levied, that operating income is constant, and that all earnings are paid out as dividends. Based on the foregoing conditions, the theory asserts that capital structure does not matter because the cost of capital remains the same, for the following reasons: 1. The risk-free interest is constant; 2. The cost of debt is always lower that the cost of equity because equity is more risky; 3. As the debt-to-equity ratio increases, the cost of equity capital will rise because stockholders will incur more risk; and 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. Later, in1963, Modigliani and Miller introduced a modification of their original model by including corporate taxes. With taxes, gearing would increase the firm's value because the interest on debt is tax-deductible, so that the investor earns more income. Thus the value of the firm increases. The cost of debt includes a tax shield depending on the tax rate: for example, where the tax rate is 30 percent, the amount of tax is reduced by the formula (1-t), so that the net expense is only 70 percent. The lower cost of debt, plus the existing cost of equity, will result in a lower weighted average cost of capital owing to the leverage. This fact may tempt one to conclude that the firm should use more gearing to such an extent that all financing will be done through debt and zero equity. In reality, companies do not drag the logic to that extreme kind of logical deduction. While historically the debt-to-asset ratios have risen overall, companies maintain capital structures that are stable with some combination of debt and equity (Brealey and Myers 1999; Keat and Mathis 2003) Years later, Merton Miller stretched the theory further by incorporating personal taxes. Such taxes would reduce but not elimiinate the benefits of debt financing. Inasmuch as the the inclusion of personal taxes lowers the income of investors, they reduce the value of the firm. b. The traditional view The traditional view holds that some gearing is beneficial as it increases the return on equity. The expected return is determined by the weighted average cost of capital. In considering a project, the company calculates the present value of all cash flows from the project when its risk does not differ from the firm's own business risk. When leverage lowers the the WACC, the value of the firm likewise increases. This is contrary to the MM proposition which says that the increased return on equity in a leveraged firm reflects the increased risk of the added debt; and that shareholders will consequently demand a higher required rate of return. Further, the traditional view holds that the required rate of return does not increase; that the WACC declines at first as leverage increases, then rises; and that there is an optimal debt/equity ratio where the cost of capital is lowest. The traditional view assumes that investors are insensitive to the increase in risk created by additional debt. Equity holders would consider management ineffective for not taking advantage of gearing provided that the after-tax cost of debt would be less than the desired return on equity. The following illustrates the debt/asset ratio plotted horisontally, and cost of capital is plotted on the vertical axis: Fig. 1: Debt ratio and the WACC (Source: Keat & Mathis, Financial Management) Note that with the WACC at the minimum, the market value of the firm is at its maximum. When the debt/asset ratio is increased the market value of the firm at first rises, then it may start to decline. It would seem that companies have an idea of what its optimum capital structure might be. Because a desirable capital structure can vary or change with time, it may be appropriate to identify an optimal range where the value of the firm is maximal rather than an optimal point in the graph (Keat and Mathis 2005, Eiteman et al 2004). Fig.2: The relationship between debt/asset ratio and market value of the firm. (Source: Keat & Mathis, Financial Management) c. The Trade-Off theory Under the trade-off model 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 tax shields and the costs of financial distress. Financial distress can arise because, as the company continues to increase its leverage (debt/equity) ratio, debt carries progressively increasing risk. Borrowing to take advantage of the tax deductibility of interest may cause lenders to require higher interest rates until such point that the firm can no longer borrow. 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 technological companies whose asset values largely consist of intangibles. The prospect of financial distress looms large when the firm can no longer meet its obligations to the creditors. Financial distress 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). The costs of financial distress include 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 the cloud of bankruptcy, and agency costs (which shall be described later in this paper). Bankruptcy costs are nominally large for small firms but less in relation to large firms. There are other financial distress costs such as the difficulty of hiring able employees and getting suppliers to cooperate, as well as the market price drop at the expense of present investors. Agency costs occur when a non-bankrupt financially troubled firm creates conflicts of interest between shareholders and creditors. Here shareholders can "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 counter these shareholder tactics by using strict conditions in debt contracts, thereby reducing shareholder flexibility and adding to the costs. d. The pecking Order Theory It has been an observed practice of many companies to have 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. At the same time, the theory holds 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 UK listed companies 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 these companies used the trade-off theory or the pecking order theory when they made financing decisions. While it was assumed that pecking order theory and trade off theory are competing, or mutually exclusive, descriptors of company practice, it was found 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 findings pointed to the fact that “firms seem to use an eclectic approach when considering financing alternatives.” Although capital structure theories contributed to the way capital structure decisions were made, the answers given by finance directors of the UK listed companies were not fully consistent with either of the main theories mentioned above. The capital structure decision is 'complex and multi-dimensional.' There are complex group processes that still have to be grasped. US empirical studies on capital structure. Some empirical studies have been carried out to survey the capital structure practices of U.S. industries and companies. In a study cited by Brigham and Gapenski (1996), the proportion of debt relative to equity was seen to vary with the kind of industry. Drug firms had, on the average, higher solvency ratios with equity roughly thrice as large as debt, followed by electronics (2:1), but there was significant variability among firms themselves. As expected, utilities, with their stable cash flows, used the highest degree of gearing, followed by retailers,. than the other industries An empirical study of multinationals discovered that the amount of gearing did not depend on industries but on the cultural practices in countries where the subsidiaries operate. Most empirical studies have concluded that country-specific environmental variables are key determinants of debt ratios. Among these variables are historical development, taxation, corporate governance, bank influence, existence of a viable bond market, attitude toward risk, government regulations, availability of capital, and agency costs. (Eiteman et al 2004) . Parent companies have access to international credit markets and can diversify their portfolios among various currencies, thus enabling them to reduce overall cost of capital (See Madura 1989). Capital structure of AIG Inc. An analysis of the balance sheets of AIG Inc. during the five-year period from 2005 to 2009 reveals a very high proportion of liabilities used to finance both fixed assets and working capital. Owing perhaps to the nature of the insurance industry the requirement of a high level of equity that serves as a norm for manufacturing industries does not apply to insurance companies which must depend on the assets "lent" to them by policy holders and asset investors. The debt-to-equity ratio in 2005 was a 8.9:1 (elsewhere normally 1:1 or even less), but this went up to 9.9 in 2007, reaching its critical peak of 15.2 :1 when the subprime mortgage crisis happened, whilst equity values plummeted due to net losses. Asset values fell but the percentage drop in retained earnings due to that year's net loss was even worse In 2009, losses continued but both assets and equity stabilised after the U.S. government intervened with a bailout package. The ratio of long term debt to total capitalisation does not tell an accurate story. The company has been using both long-term and short-term debt to finance fixed assets as well as working capital, which could only be done safely banks and other creditors regularly rolled them over, thereby taking on the characteristics of long-term liabilities. The following table shows some five-year financial data and the calculated ratios that pertain to long-term solvency and the characteristic of the financial structure. Item (in billion British Pounds, except the ratios) 2009 2008 2007 2006 2005 Net income (loss) -10.90 -99.30 6.20 14.00 10.50 Total Assets 847.50 860.40 1,048.40 979.40 853.10 Total Liabilities 777.80 807.70 952.60 877.70 766.70 Total Long Term Debt (LTD) 113.30 137.10 162.90 135.50 100.80 Total Current Liabilities 664.50 670.60 789.70 742.20 665.90 Total Equity 69.80 52.70 95.80 101.70 86.30 Capitalisation (LTD + Equity) 183.10 189.80 258.70 237.20 186.50 LTD/Equity (capitalisation) ratio 0.62: 1 0.72: 1 0.63: 1 0.57: 1 0.54: 1 Debt/Equity ratio 11.1: 1 15.2: 1 9.9: 1 8.6: 1 8.9: 1 Gearing (Debt/ Assets) ratio 0.92 0.94 0.91 0.9 0.89.9 Table: Selected financial data and ratios related to capital structure. (Source of raw data: MSN) Conclusion Because of the disruption caused by the financial crisis that began in 2008, it is difficult to determine whether AIG still has a long-term finance policy, given that it is presently preoccupied with selling its assets in order to repay the government. The firm also came under severe public and official rebuke for disclosing that it was going to pay performance bonuses to its executives. Its stock having fallen precipitously and still unable to recover to any significant extent, very few analysts are studying its fundamentals. Only the financial data derived from its financial statements give us something to reflect about its long-term financing policy. The company's vision of the future is being blocked by the present crisis. Unless the present difficulties the company is facing are removed, the future strategic direction, including that of long-term finance, cannot yet be determined with a degree of confidence. When that happens it shall have taken into account the lessons learned from the crisis. 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 10, 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. Eiteman, DK, Stonehill, AI, & Moffett, MH, 2004, Multinational business finance, 10th edn., Pearson Education, Inc., NY Keat, PG & Mathis, FJ 2003, Financial Management. 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