The Concept of Capital Structure - Essay Example

Table of Contents Introduction 2 Explanation 2 Evaluation 4 Net Income Approach 5 Net Operating Income Approach 5 Traditional Approach 5 Modigliani Millar Approach 6 The Tradeoff Theory 6 Conclusion 6 References 8 Introduction The company’s balance sheet is composed of two major portions, i.e. the right hand side represents assets that are owned by the company and the left hand side represents financial resources that are used by the company to finance its assets and ongoing operations, this arrangement is known as the financial structure of a company. The company’s value and its exposure towards financial risk are directly dependent upon the management of its debt to equity mixture. The management of this debt to equity involves the optimization of the company’s capital resources in relation to its long term debts. However, unlike the financial structure of the company, the capital structure doesn’t include the current liabilities. There are numerous factors that can affect the combination of debt and equity, which in turn affect the company’s wealth and market value, including the company’s financial policies, the external economic conditions of the country where the company is operating, the internal cash flow and net worth of the company, etc.… These factors are aimed to achieve an optimum level of the combination of debt and equity with a purpose to maximize the company’s market worth and financial wealth. It has been stated by the Miller and Modigliani (1985), that it is the company’s investment policy that can affect its debt to equity combination because if a company has a constant investment policy, regardless of the engagement and tax expenses, then the company’s financing policy shall have a negligible influence over the market value of the company. Whereas, the cash flow and static trade off approach states that the company’s debt to equity combination is highly dependent upon its financial policies regarding fund raising for future financing and payments of the dividends to the shareholders because these measures have a direct impact upon the decision making power of the managers regarding any opportunistic activity. (Jensen, 1986). However, most of the research studies suggest that the company’s net market value and financial worth can also be greatly influenced by the country’s economic conditions, i.e. the interest rate, exchange rates, inflation and GDP. For example, a number of companies in Germany, UK, Italy and France are affected by the great depression of 1987 because they were failed to take into account the economic factors of the country. (Adrian. & Songshin, 2009). Explanation Achieving an optimal capital structure is one of the most complex and important issues of an organization because managers of a company have to decide that what sort of long term debt to equity ratio should be maintained that can help the company to achieve a sustainable value in the market. The capital structure of a company is the best determinant of its market value and financial soundness, it represents the company’s capabilities to finance its long term projects and also tell us about the operational competency of a company. Some people observe that the company will be in a better position, if it is capable of acquiring a considerable amount of long term debt easily from the market, but depending upon long term debts for financing the company’s ongoing and future projects will expose it to a high financial risk related to its earning streams. (Ross, 1977). But it is also an unavoidable fact that the higher rate of debt or cash in the business ensures a high rate of return in the future, but the high dependence over debt will lower down the stock price of the shares of the company. However, at the same instance the higher rate of return over the investment will make the business an attractive investment venture for the investors, which will nullify the fall in its stock price and the company’s shares, will be once again traded at higher stock value. Therefore, the optimal capital structure of a business is the one, where the risk and return associated with the business of a company strikes a balancing figure and make it capable of achieving its ultimate goal of stock price maximization. (Lewis. & Brander, 1986). The other important factor for maintaining a competent and optimal capital structure in an organization is the competencies of their managers because managers are the key personnel, who have to make the decision regarding the designing of a company’s capital structure. There are usually two types of managers in an organization, i.e. high performer or high ability managers and low performer of low ability managers. Low ability managers are those, who can acquire debt from the market, but they are unable to utilize the debt in a proper manner, which results in the loss of financial resources without any increase in the shareholder equity or the company’s net earnings (Demerjian, et al, 2013). . Therefore, they are unable to repay their debt and ultimately the business will face bankruptcy. However, on the other side high performer managers are those, who are competent and hard workers and whenever they acquire any sort of debt from the market, they utilize it in a very effective manner. As a result the stock price of the company and its profitability are increased and make them capable of repaying the debt along with the amount of interest thereon. This means that the high performer managers ensure a strong and the optimal capital structure of the company. (Meckling. & Jensen, 1976). Another factor that was initially ignored by a number of financial managers to take into account before assessing the worth and competency of the capital structure of their organization was the economic conditions of the country or the region where the company is operating. Economic conditions refer to the overall effect of different economic forces over the company’s capital structure, i.e. GPD rate, Interest rate, exchange rate, etc. The interest rate and exchange rate directly affects the capital structure of the company because increase in both of the rates causes a rise in the cash flows required to cover the debt, hence, causes insecurity among the debt issuers regarding the extent of return they will get over their debt. On the other side, it also makes the shareholders and management of the company nervous about the fact that an increase in the interest and exchange rate will lower down the value of earning per share (EPS). The increase in the mentioned values will increase the expenses resulting in a reduction in Earnings and hence, the EPS. The effect will extend to the stock price of the shares, which will make it difficult for the managers to keep a competent and balanced capital structure for their organization.The GDP growth of a company also affects the capital structure of businesses because a growing and positive GDP rate attracts the managers to avail different opportunities available in the market and they will be encouraged to raise finance for these prospective ventures, which will increase the debt of the company and ultimately disturb the optimal capital structure. Apart from these factors certain political and environmental factors have also an indirect impact over the capital structure of a company, i.e. the instable government and law and order situation in a country can cause a downturn in the economy, which can affect the profitability of a company, tax rates set by the government have a great impact over the capital structure because companies tend to finance their projects over debt instead of their equity due to the fact of getting tax rebates from the government. (Mujlf. & Mayer. 1984). Evaluation The capital structure is the ratio of a company’s long term debt to equity, which includes the long term debt, capital, preference shares, and overall equity of a company that is used to finance the company’s operational and investing projects. The main objective and goal of a better financial management is to maximize the company’s net worth and market value by maximizing its stock price and increase the returns for shareholders’ equity. To achieve this objective the company is required to choose such a financial mix of the debt and equity, so that the managers will feel confident and enjoy long term wealth of the company; such a financial mix is known as the optimal capital structure. The weighted average cost of the company’s capital will be maintained at the minimum possible level, which will increase the earnings that is related to the shareholders equity. There are numerous of theories used to determine the effectiveness of the capital structure, these theories are discussed below. Net Income Approach The supporter of this approach states that the capital structure decision is related to the valuation of the company because changes in the financial leverage of the business will automatically change the total value and cost of capital of the company. They state that if the ratio between the earnings per share and the income of a business before interest and tax increases, it will cause a corresponding decrease in the weighted average cost of capital, which will increase the stock price of the company’s share and its overall worth in the market. (Lasfer, 1995). Net Operating Income Approach It is just against the net income approach, which means that the supporter of this theory states that the financial leverage and debt of a company is not concerned with the increase and decrease in the net worth and market value of its share because the impact of increase in debt is nullified by the simultaneous increase in the return rate by the shareholders’ equity. According to this approach the market value of a company is actually dependent upon the business risk that is faced by the firm and the related operating income of the business. (Brealey., Myers and Allen, 2005). Traditional Approach Both the operating income and income approaches are dealing at extreme levels, whereas this approach explains a moderate and mid-level approach towards the capital structure. According to this approach it is the best balanced combination of both the equity and debt that leads an organization’s capital structure to an optimal level. This approach suggested that the market value of the firm increases due to the fact that the shareholders are capable of perceiving the market risk at the right time and undertake certain reformative steps to solve them out through accepting premiums for the risk undertaken by the company. (Damadoran, 2001). Modigliani Millar Approach This approach is also known as the MM approach, which provided a base for the modern approaches towards the Capital structure of a company. The approach is much alike the operational income approach and the supporter of both the approaches suggest that the market value of the company is independent of the equity and debt combination or ratio. However, this approach differs from the former one because it provides behavioral and operational justification at any degree of leverage for the constant cost of capital. Whereas, such justification was not provided before by the net operating or any sort of other approaches. (Miller. & Modigliani, 1963). The Tradeoff Theory This theory is based upon the concept of tradeoff between two quantities, i.e. the debt incurred by the company for financing a project is offset by the expected benefits that can be derived from it. This approach states that the managers should use such an amount of debt and equity for the financing of the company’s activities that can balance the cost and benefits associated with them. This theory suggests that managers should make their choices very smartly and according to the supporter of this theory, managers should use debt for financing the company’s activities because they can get rebates from the government tax collecting authorities in respect of such investments. (Dastgir, 2003). Conclusion The above discussion and evaluation of different theories and approaches towards the concept of capital structure has concluded that it is the most important function of a company regarding the decision making activities of the management because management can make new investments and arrange funds for the ongoing activities on the basis of their capital structure. It is also observed that the most appropriate concept that can be used to check whether the capital structure of a company is at its optimal level or not is the MM approach because it signifies the non-quantitative factors as well that can affect the capital structure of a company. 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