Optimal Capital Structure under Corporate and Personal Taxation - Essay Example

Corporate Finance Introduction Financial leveraging is a sensitive balance for companies, requiring that the capital structure ofa company is set optimally, such that the increased access to sources of funding is balanced with the fixed charges that arise out of it (Bloomfield, 2005). The value of a firm increases with the decrease in the cost of capital (Atkinson, 2005). Hoad Ltd is a company in need of finances for capital expenditure, involving adding to plant capacity and modernising manufacturing equipment. However, the internal sources of finance for the company are not sufficient to cater for this capital expenditure. Additionally, the company operates in a country whose stock exchange market is underdeveloped, such that it is unable to raise the required capital through the stock exchange. Different sources of finance exists from which companies can be able to access external funding, on the event that the internal sources of funding are inadequate to finance its capital expenditure. However, each of the external sources of capital comes with its associated costs. The purpose of any investment made by a company is to increase the value of the firm (Barrow, 2004). Thus, despite the fact that Hoad Ltd may have access to different sources of external financing, the company has to work towards balancing the source of capital and its associated costs, so that the company can arrive at the optimum capital structure. The financial leverage of a firm is measured based on its ratio of owners equity to the amount of debt held by a firm. When the debt amount is too high compared to the owner’s equity, the risks associated with business increases, and its stock valuation also depreciates (Bloomfield, 2005). In this respect, a high amount of debt affects the value of a company negatively. Further, the dividend policy applied by a company affects the value of the firm, just as the level of debt would affect the firm’s value. This is because, if the company pays too much dividend to its shareholders, it may not have sufficient finances remaining to cater for its capital expenditure (Brigham and Houston, 2009). On the other hand, if a firm pays too little dividend to its shareholders, the valuation of the firm’s share on the stock market is affected negatively, by reducing the price of the company’s share on the stock market (Brigham and Houston, 2009). Thus, this analytical discussion seeks to identify and examine critically the alternative methods of finance for Hoad Ltd, and how the level of debt and dividend policy can affect the value of the company. Discussion The fact that Hoad Ltd does not have access to the stock market as a source of its external source of finance means that the company has to look into other alternatives. There are different external sources of capital that a company can apply to fund its capital expenditure. However, the choice of which alternative the company selects has to depend on various factors, for example the ease of accessibility of the source of finance, the costs of obtaining the external funding, and the implication of the source of external financing on the overall capital structure of the company (Nour, 2009). Thus, the following are some of the external sources of financing that are available to Hoad Ltd: Debenture Financing Hoad Ltd is seeking to finance capital expenditure on the expansion of its plant facilities as well as the modernisation of its equipments. Unsecured debenture financing is one of the external sources of financing available to Hoad ltd, comprising of the company obtaining a loan which is not backed up by collateral, in return for the repayment of the loan within a set schedule (Barrow, 2004). Debenture financing requires that a company pays a fixed rate of interest on the borrowed funds for the period between borrowing and the maturity of the loan, whether the company makes a profit or not (Cobham and Suzuki, 2005). The advantage associated with debenture financing for Hoad Ltd is that this source of financing does not require the company to attach any of its assets as collateral. In addition, since the debenture credit is not secured, the lenders of the credit to the firm are considered as mere creditors, and for that reason, the debenture creditors are not to be treated in preference during the liquidation of the firm (Atkinson, 2005). This therefore means that debenture capital is a less risk way of raising capital for the company, owing to the fact that the company does not necessarily have to pay the debenture holders first in case of liquidation, since the unsecured debenture holders acts as general creditors to the company. The other alternative form of financing available to Hoad Ltd under the debenture financing is the secured debentures. Secured debentures means that the company can obtain some loans from the debenture holders, in return for the debenture holders attaching their interest to certain assets of the company, as the collateral (Erickson and Vinturella, 2003). In such a case, the debenture holders have a legal interest in the specific asset of the company that is attached as collateral. Therefore, on the event of the failure or the liquidation of the company, the debenture holders hold the first preference for payment of the dues arising from the disposal of the asset (Atkinson, 2005). The debenture holders can only lay a preferential claim on the specific asset they have attached their interest, and thus they may recoup all or part of their debt from the disposal of the asset based on its value, before the shareholders can be considered. This external source of finance for Hoad Ltd is advantageous, owing to the fact that it does not create a legal risk to the whole of the assets belonging to the company. The major disadvantage associated with secured debentures as a method of financing a company is that it is not suitable for weak companies with few assets. The last mode of external financing that Hoad Ltd can obtain through debenture financing is through convertible debentures. Convertible debentures refer to a source of finance for a company where the debenture holders have an option to receive their repayment either in form of cash or stock (Cobham and Suzuki, 2005). The advantage associated with convertible debenture is that it carries a lower interest rate than the conventional business loans, thus lowering the cost of capital to the borrower company. The major limitation associated with debenture financing is that it is a fixed-rate repayment method of external financing, requiring that the company must pay the interest whether it makes profit or not. The overall effect is that debenture financing as an alternative finance method for Hoad Ltd will entail a substantial fixed cash outflow throughout the term of the debentures, until their maturity (Barrow, 2004). Debenture financing as a method of financing is suitable for Hoad Ltd, owing to the fact that this form of external financing is a low-risk financing option for the company. Additionally, it is one of the possible options available for Hoad Ltd to offer its stock to more shareholders even under circumstances where the company has already been limited by the underdeveloped stock exchange market in the country where it operates. This is because; Hoad Ltd can easily issue convertible debentures, where the debenture holders have an option to obtain their repayment in the form of either cash or stock. Additionally, debenture financing does not affect the value of the firm through its dividend policy, since the debenture holders are treated like general creditors to the company, thus do not affect the gearing ratio of the company (O’Brien and Ryan, 2000). Further, debenture financing does not affect the value of Hoad Ltd through the amount of debt, since the debenture financing credit is treated as a general credit to the company, meaning that it rarely influences the gearing ratio of the company. Thus, the suitability of debenture financing as an external source of finance to Hoad Ltd is that it will enable the company to access low-risk credit, while at the same time maintain the capital structure of the company unaffected (Atkinson, 2005). Most importantly however, debenture financing as a method of finance for Hoad Ltd actually increases the value of the firm. This is because; the interest paid on the debenture holders is treated as an expense to the business, which is eliminated for taxation purposes (Brigham and Houston, 2009). This therefore means that debenture financing offers Hoad Ltd an opportunity to reduce its taxable income, through treating the debenture interest as an expense to the income of the business. The overall effect is that Hoad Ltd pays less tax, and thus is left with a higher profit to be distributed amongst its shareholders. This does not only help to ensure that the company increases its Earnings per Share (EPS given to its shareholders, but that the company has a potential for gaining in the valuation of its shares (Barrow, 2004). This is simply because the payment of high dividends to the company share holders is associated with a favourable valuation of the shares of the company in the stock exchange market. Simply put therefore, debenture financing as a method of external finance for Hoad Ltd overcomes the challenge posed by both dividend policy and debt levels on the value of a firm. Bank Loans Bank Loans is another alternative finance method accessible to Hoad Ltd. Bank loan as a method of financing carries the advantage of ease of accessibility, which then means that the company can access the financing it requires for plant expansion and modernisation of its equipment within a short time, if it approaches banks (Sherman, 2005). The other advantage associated with bank loans as a method of finance for Hoad Ltd is that this method can offer long-term option for the company, ranging from five years and up to twenty-five years, meaning that the company can repay the debt for an extended period of time (Spinelli, Timmons and Zacharakis, 2004). Howe ever, the major disadvantage that is associated with bank loans as a finance method for Hoad Ltd is that bank loans requires that a firm produces collateral in form of its assets or the personal assets of its shareholders. Further, bank loan as a method of financing the capital expenditure for Hoad Ltd is disadvantageous, since this method carries with it a high interest rate, which is also subject to revisions and change in the course of the term loan (Atkinson, 2005). The overall effect is that bank loans as a method of financing Hoad Ltd capital expenditure can be very expensive in the long-run for the company. Nevertheless, the advantage associated with bank loan as a method of financing the capital expenditure of the company, in relation to the capital structure of the company, is that the interest payable by the company to the bank is treated as an operation expense for the company. This therefore means that the bank loan interest reduces the tax payable by the company on its revenues, since the interest expense is exempted from taxation (Ince and Owers, 2009). The bank loan financing alternative is therefore capable of lowering the overall cost of capital of the Hoad Ltd. Further, bank loan finance alternative is advantageous to the company’s dividend policy, since it does not affect the dividend payout by the company to its shareholders, since the bank loan interest is not deducted from the profit of the company, but rather treated as part of the company’s expenses. Nevertheless, the major disadvantage associated with bank loans as a finance alternative for Hoad Ltd, when the capital structure of the company is concerned, is that bank loans increases the debt amount of the company. This then means that with a high bank loan, the debt to equity ratio of a company is reduced, meaning that the risks associated with the company now increases (Auerbach and Hassett, 2007). The increase in the financial risks associated with a company in turn means that the company’s share valuation at the stock exchange market is affected negatively. The favourable share valuation of a company in the stock exchange market emanates from a company’s low-risk financial status, allowing the price of the share of the company to increase (Atkinson, 2005). However, with a high-risk financial status, the share price of the company decreases. This in turn affects the value of the firm unfavourably, considering the fact that the value of a firm is greatly based on its asset valuation, as well as the share price valuations. Therefore, while bank loans may be an alternative source of capital for Hoad Ltd, it has the potential of affecting both the capital structure and the value of the company negatively, if the bank loans required to finance the plant expansion and the equipment modernisation of the company are high in amounts. Venture capital Venture capital is yet another finance method available to Hoad Ltd. Despite the fact that venture capital is mostly offered to businesses at the initial stage of start-ups, venture capitalists also invest in companies whose potential for growth and profitability is high. The advantage associated with venture capital as a source of funding for companies is that it has the potential of generating above average returns for a company (Modigliani and Miller, 1963). The other advantage associated with venture capital as a method of finance for companies is the fact that venture capitalists do not only provide financing for companies, but they also participate in the management of the company through offering operational, strategic and financial advises (Atkinson, 2005). Venture capitalists can also offer business connections to different areas that can increase business for the company. Nevertheless, the disadvantage associated with venture capital as a method of finance for companies is its limited accessibility (Denis and Osobov, 2008). Venture capitalists only invest in specialized forms of business, most especially those with a novel idea and a high potential for growth and profitability. This means that accessibility to venture capital as a financing alternative for Hoad Ltd is highly limited. Additionally, venture capitalists highly participate in the management and control of a company, to ensure that it runs in accordance to their vision. This means that a company financed through venture capital has a high potential of losing management control. Most importantly however, in relation to capital structure and value of the company, venture capital is an advantageous alternative of financing for Hoad Ltd. This is because; the company is not obliged to repay the investment that has been made in its business by the venture capitalists (DeAngelo and Masulis, 1980). The overall effect is that venture capital does not alter the capital structure of a company, because it does not increase its debt amount. Consequently, venture capital improves the value of a company, since it ads investment into the company, which the company does not necessarily have an obligation to repay (Barrow, 2004). Nevertheless, the greatest disadvantage associated with venture capital is that it influences both the dividend policy and the Earnings per Share (EPS) payable to the shareholders. This is because; the venture capitalists have to share in the profit of the company just as the shareholders do. The fact that the venture capitalists have to share in the profits of a company through earning a certain fixed rate means that the dividends payable to the shareholders may be lower, which may then affect the valuation of the price of the shares of the company in the stock market. Leasing Leasing is a financing method available to Hoad Ltd, which entails the company obtaining and using the desired equipment and machinery on credit (Brigham and Houston, 2009). One of the capital expenditure objectives of Hoad Ltd was to modernise its equipment. Thus, the company can lease and use the modern equipments from a leasing company, in return for the company paying a fixed amount of money on regular basis, until it has been able to fully cover the cost of the equipment (Atkinson, 2005). Leasing as a method of financing a company is advantageous since it makes it possible for a company to access and use machinery and equipment that it has not yet paid a full price for. This means that the company is able to generate more revenue with assets that it does not entirely own, making it possible for the company to avoid tying its capital on capital expenditure in machinery and equipment, when it could have used those resources in another beneficial manner (Denis and Osobov, 2008). Thus, through leasing, Hoad Ltd can be able to use modernised machinery and equipment obtained from a leasing company, and in turn release the capital that would have been used for this purpose to cater for plant expansion. The disadvantage associated with leasing however, is that the company does not have the ownership of the equipment until it completes the repayment, while at the same time it has to incur the maintenance expenses (Spinelli, Timmons and Zacharakis, 2004). The most significant leasing advantage however, which is related to the capital structure and the capital value of the company, is the fact that leasing does not affect the capital structure of the company, while at the same time it does not influence its dividend policy. Leasing is a form of capital financing method that is treated as a general credit to a company, such that the expenses associated with the repayment of the equipment and machinery obtained through leasing is treated as tax-exempt business expense (Auerbach and Hassett, 2007). Leasing helps in reducing the amount of tax payable by a company. The regular lease repayments increases the company’s non-taxable expenses and reduces its tax burden. The reduction in taxation therefore means that the value of the company is increased, since the shareholders of the company can now get higher Earnings per share (EPS) (Denis and Osobov, 2008). Further, leasing as a method of financing does not increase the amount of debt of a company, since the leased equipment or machinery becomes part of the assets of the company. In this respect, leasing improves the value of a company, while it does not alter its capital structure. Conclusion Hoad ltd has several finance alternatives that are available to cater for capital expenditure on equipment modernisation and plant expansion. However, while there are several options that are available as methods of financing the company’s capital expenditure, there are different costs of capital associated with each of the financing alternatives. The costs of capital involved in each of the financing alternatives may alter the capital structure of the company or increase its amount of debt, which might in turn affect the debt/equity ratio of the company, and thus influence both the dividend payment and the value of the firm. Debenture financing, bank loans, venture capital and leasing are some alternatives available for financing Hoad Ltd capital expenditure. Nevertheless, debenture financing, leasing and venture capital offers the suitable alternatives, since they do not affect the debt amount or alter the capital structure of the company. Thus, these alternatives improves the value of the company, through leading to high earnings per share for the shareholders, and thus resulting in favourable share price valuation and consequent improved value of the company. References Atkinson, A.B. (2005) New sources of development finance, Oxford University Press. Auerbach A. and Hassett, K. (2007) The 2003 dividend tax cuts and the value of the firm: An event study. In: Auerbach A, Hines J, Slemrod J (eds) Taxing corporate income in the 21st Century, pp 93–126. Barrow, P. (2004) Raising finance: a practical guide to starting, expanding & selling your business, Kogan Page Publishers. Bloomfield, S. 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