Capital Structure, Leverage, and Dividend Policy - Essay Example

Capital structure, Leverage and Dividend Policy Trade-offs that firms must consider when they determine their target capital structure The structure that would maximize the stock price of a firm is known as optimal capital structure, which is very useful in determining the optimal structure. The optimal structure can be studied by a firm’s manager to set a target capital structure, such as 40% debt. When the debt ratio falls below the target level, it becomes prudent for the management to raise capital by issuance of debt, on the contrary, when the debt ratio is above the target, equity is used. Time is dynamic, and this means that target will be changing from time to time, but ant any given time the management must have a specific debt ratio. Therefore, setting the capital structure involves a trade-off between risk and return. This is because using more debt will enhance the risk borne by shareholders to increase, and also the using more debt will increase the expected return on equity. The trade-off of balancing between the risk and return is quit a task that managers must juggle about, this is because the higher the risk that is related to using more debt will tend to lower the stock price, nevertheless the higher debt-induced raises the expected rate of return. Due to this scenario a balance between return and risk has to be maintained in order to maximize the stock price. Firms also need to consider their tax position. This leads to firms considering the application of loan capital since its interest is tax deductible thereby reducing the effective cost of debt. As such, a firm that has most of its income unsheltered will perceive debt capital as the most advantageous form of financing to reduce taxation. However, firms that feel that they have sheltered most of their incomes through other ways such as tax loss carry forwards, interest on outstanding debt or depreciation tax shield have no reason to prefer use of debt capital as it adds no value for them as their income is already protected from intense taxation. Financial flexibility is also a contributing factor when a firm is determining their target capital structure. This relates to the ability of a firm to raise the needed capital to finance its projects and operations regardless of the adverse nature of the market. Firms determine their capital structures depending on the supply of capital that is available for them. This implies that, for a business to have a steady supply of capital, it is easier to use debt capital in order to keep the operation of the business running and stabilize the activities of the company. The effects that debt financing has on the firms risk and cost of capital Debt financing has an effect on two types of risk, business risk and financial risk. Business risk can be examined by the firm’s operation and its capacity to uphold operating income. Financial risk is the firm’s capability to meet its financial obligation. Debt financing has a close link with the firms risk, debt financing will greatly affect the firm’s risk. Debt is also capable of reducing the cash flow of a firm, when the capital structure is tilted towards more debt, managers will be forced to be disciple in order to finance the debt. This is because if the debt is not financed the firm can be declared bankrupt which is not a risk that the management will be willing to take. Debt financing imposes restrictions on the company in terms of distribution of the wealth of the business. This is because it affects the capital structure of the company. A company that uses debt capital to finance its operation faces various regulation such as distribution of limited earnings after the reduction of interest payable on the loan. As such, debt financing increases the risk of the business and the cost of capital. When the company uses great amounts of debt to finance it operations, there are instances of negative results to be experienced. While the only benefit notable in this case is to reduce the taxation liability of the company, debt capital raising the interest expenses, raising anxiety and uncertainty on the part of the shareholders due to the reduction in earnings per share, and the reduction in the stock price of the company. The use of debt capital can worsen the fate of shareholders in case the company gets declared bankrupt. This is because the company has accumulated a lot of liabilities from the loan that will need to be paid before the rest of the earnings are distributed to them. As such, shareholders risk to lose much on their investment if anything would go wrong with the investment. Summary of the capital structure theory There have been many theories that have been proposed regarding capital structure by various scholars around the globe. The two major theories that can be used to summarize capital structure theory are: trade-off theory and signaling theory. Trade-off theory- this theory was developed by Merton Miller and France Modigliani, which suggested that firms should consider the use of debt in their capital structure since tax deductibility of interest payment has a lot of benefits. They set very restrictive assumptions that indicated the value of a firm is enhanced by if more and more debt is used. They even indicated that the value of the firm will be maximized if it is 100% financed by debt. The limitation of the theory is that it ignored the costs that are related with bankruptcy. Taking into consideration the costs of bankruptcy, the advantage of tax deductibility of debt is more than offset by increasing in the cost of debt and the cost of equity that result from the risk allied with the firm’s heavy use of debt. Signaling theory- this theory suggest that managers and other top executives that are within a firm possess a lot of information as compared to outside investor about the firm. The information that the mangers can possess include ways in which the firm can raise capital. Why firms in different industries have different capital structures Business risk is a factor that influences the optimal capital structure, firms in different industries have different business risk. This is means that capital structure will vary considerably from across different industries. If for instance biotechnology companies will have a complete different capital structure as compared to firms in the food processors industries. Consequently, capital structure can vary from firms within a given industry. Because business risk is different among firms in different which in turn will make the capital structure to vary let’s consider the factor that influence business risk. One of the factors is competition, different firms depending on the industry will have different level of competition. Demand will also vary from firms of different industries, input cost will is also not constant in different firms. Another factor is that the regulatory risk and legal exposure will vary from firms of different industries, legal factors that could have a considerable effect on the capital structure might include tax and huge costs that they are imposed, such as a tobacco company and Oil Corporation, this will definitely influence the capital structure to adapt to this regulation. It is also very important to note that the difference will depend to a large extent the type of operations, and stability of the sales that are allied with the firm. Why some investors like the firm to pay more dividends while other investors prefer reinvestment and the resulting capital gains A firm can pay cash or stock dividends when it decides to redistribute wealth to their shareholders. The question an investor should consider asking at this point is whether the cash would be more profitable when retained in the firm to be used in the investment of new or existing projects or whether the cash would be beneficial to the shareholders when received to be used in investments elsewhere. The choice to be made will favor the investment that will increase the overall value of the firm or that of the shareholders. Proponents of stock dividends argue that stocks are a good method of reinvesting as they give shareholders an opportunity to enjoy maximum flexibility. As opposed to cash dividend that is prone to taxation, stock dividends are not taxable and therefore it is a good method of reinvesting in tax-free business. A firm decides to pay cash dividends to its shareholders when it is perceived that the cash to be received by the shareholders will be helpful in helping shareholder diversify their investments and maximize their yield in the long run. Payment of cash dividends has been successful used to impose fiscal discipline to the company as it prevents mismanagement and squandering of the shareholders wealth as shareholders handle their wealth themselves through cash dividends. Furthermore, it gives the shareholders a choice to control their wealth. The wise shareholders can reinvests the cash while those who chose to use the cash for other activities are free to do so. Reinvestment of the cash dividends is a wise decision as it allows a shareholder to earn greater share of the company’s profits in the future, especially when reinvestment is done when the company’s share prices are down. Various trade-offs that companies face when trying to establish their optimal dividend policy Bond indentures; debt influence the company’s optimal dividend policy as it shrinks the earnings of the company leaving less cash to be distributed to the shareholders. This is mostly so if the company uses debt capital from loans to generate revenue. Loan requires that the company adjust its dividend policy in compliance with the regulations of the loan. As such, dividends cannot be paid unless the company exceeds the required amount of earnings. Preferred stock restrictions; limitations on preferred stock also affects the implementation of a company’s optimal dividend policy. When a company has expressly indicated its preferred stock which is then omitted during the distribution of dividend, payment of common dividends is delayed until the company honors the payment of preferred dividends. Impairment of capital rule; the capital rule relates to earnings of the company as reflected in the retained earnings in the balance sheet. This rule was implemented in order to safeguard the interested of the creditors. As such, the company’s optimal dividend policy is influenced by this rule as it requires the company to pay all the creditors from their retained earnings after which the remaining earning ware distributed to the shareholders. This rule was formulated in order to protect the rights of the shareholders especially where businesses opt to dissolve the businesses and share all its assets leaving the creditors counting losses. Amount of available cash: the company cannot share that which it has not generated from the shareholders’ investment. As such, when formulating the company’s optimal dividend policy, the company needs to consider the amount of cash they have available. When the company is facing a shortage of cash, dividend payment may not be possible or may be very little. On the other hand, huge reserves of retained earnings can increase the amount of cash paid out to shareholders in form of dividends. Differences between stock splits and stock dividends Both stock splits and stock dividends influence the capital structure of a company. Stock dividend are another way by which shareholders receive their dividends. However, they receive stocks instead of cash. Stock dividend therefore occurs when a company decides to purchase additional stocks for the shareholders instead of giving them cash payouts. This method of payment of shareholders earnings is applied by firms that wish to pursue growth by retaining the cash through reinvestment. In this case, the company reinvests the money in stocks which are then issued to the shareholders as additional stock. Contrary to common belief, stock dividends do not add any value as far as proportionate ownership of the company is concerned. This is because shareholders retain their proportionate wealth as they did before the issuance of the stock dividend. On the other hand, stock splits occur when the number of shares are increased to increase the liquidity of the stock. This is done in situation where the firm perceives that there is need to maintain the stock price at an optimal level when the stock price rises too high than normal. Stock splits reduce the par value of the share for all the stocks of the company while the stocks increase by number. The more the shares outstanding of the company’s stocks, the more the liquidity of the company. As such, the company is able to create an enabling environment for investors to buy regular lots. The fact that the shares are increased in number doesn’t mean any additional value in the shareholder’s wealth since the par value is reduced by half. Advantages and disadvantages of stock repurchases vis--vis dividends from both investors and companies perspectives The greatest advantage of stock repurchases is that it reduces the cost of obtaining outside financing. Getting capital to finance company projects is very expensive as it is characterized by high interest rates that reduce the earnings of the company. On the other hand, using internal source of financing helps the company to take advantage of zero interest rates of using retained earnings. As such, the company and the shareholders both benefit from stock repurchases as the cash that would otherwise be paid to shareholders is used to finance the company while shareholders receive dividend instead. However, stock repurchase is prone to fraud and mismanagement of the shareholders wealth. The shareholders may also lose on investment elsewhere. Dividend payment is beneficial to both investors and the company. Having a clearly set out dividend policy reduces the uncertainty of the investor therefore leading to a decline in the capital costs. The shareholders get full faith on the credibility to the business which translates into higher stock prices for the company. This benefits the business though increased value associated with higher stock prices and increase investment. However, payment of dividends in also associated with negative aspects. Sound payment of dividends can reduce the flexibility of the company. Work Cited Altman, Edward I., ed. Financial Handbook 5th ed. New York: John Wiley & Sons, 1981. Print. Brigham,E Houston, J. Fundamentals of Financial Management. Cengage Learning, 2009.Print. Cottle, Sidney, Roger F. Murray, and Frank E. Block. Graham and Dodds Security Analysis. New York: McGraw-Hill, 1988. Print. Davis, Henry A., et al. Building Value with Capital-Structure Strategies. Morristown, NJ: Financial Executives Research Foundation, 1998. Print. Gifford, Dun, Jr. "After the Revolution." CFO, July 1998. Print. Kochhar, Rahul, and Michael A. Hitt. "Linking Corporate Strategy to Capital Structure." Strategic Management Journal, June 1998. Print. Leland, Hayne E. "Agency Costs, Risk Management, and Capital Structure." Journal of Finance, August 1998. Print. Read More