Analysis of Companys Capital Structure - Example

Full title topic Introduction The aim of this white paper is to show that either the individual can test that the company’s capital structure is influenced by their past experiences or not. Later a small examples shows the past experience impact on the capital structure decisions. Lastly, the capital structure decisions effect on pecking-order theory and trade-off theories are given. The capital structure1 of the firm includes mainly includes the head of “equity” and “debt”. The proportion of these together actually forms a complete capital structure. Then the share price of the firm in the market is low, than the firm usually uses more debt financing than the equity financing, whereas, when the market price of the shares are higher than the firm uses more equity financing than the debt financing2. The capital structure of each firm usually changes each year due to many internal and external factors that directly affect the capital structure of the firm. Below a complete description about the affect of past experience on the capital structure is given with their impact on trade-off and pecking order theories. A simple test can show that the past experience of the companies has affected their capital structure decisions and this simple test is their historical market values of the shares. The market valuations3 of the firm affected a lot in the capital structure decisions. If we organize an analysis on the prices of equity than we come to know that the prices of the firm share didn’t remain same and fluctuates a lot. This directly affects the capital structure of the firm. According to Taggart and Marsh the past market-to-book ratios are taken by the companies to understand that what should be their market structure in the future. Usually for this, Weighted Average method is chosen by the firm to weight all the past market-to-book ratio to know that when and how much equity they should given in the market and how much financing should be taken from debt side. Usually we can test the affect of past experience on the company’s capital structure if we know there past financial structure. Net debt issues4 and net equity ratios of the firm shows that either they have any past experience affect on the companies capital structure. Suppose a firm experiences high return on equity when they raised their financing through equity during high market valuation. In the next year if the market valuation rate remains high than the firm will again finance their firm by raising the equity. Moreover, complete analyses of the firm financial and capital structure will show that either the firm uses their last year experiences or mainly depend on the current market ratio. Baker and Wurgler (2002) documented that historical data and experience effect time equity issuances but only when the market valuation has persistent effect on the firm. Similarly the taxation structure of the market in which they are dealing has high effect on the capital structure. If the firm experiences that they are paying high interest rate on the debt and incurring a huge cost, then according to their experience the next year they will launch more financing through equity than the debt5. Equity price shocks Equity price shocks6 are the main point through which you can test the effect of past experience on the capital structure. Stock return on the equity financing is the primary determinant of the capital structure in the future. Moreover, stock to capital structure has great impact on the leverage. Empirical evidence Suppose there is a company ABC, the firm in last year experiences is shown below with their capital structure. Firm debt financing = $150000 The interest rate on the debt is 22% Total interest that the had paid in last year is = $33000 Firm equity financing = $100000 The share rates are = 9% Total return on the equity to shareholders7 in last year is = $9000 The above mentioned examples of the firm shows that the firm had paid more on debt and less on equity due to high interest rate in the last year. This experience of the firm would have great impact and in next year they will issue more equity to gain more financing rather using debt to finance their business. According to Kalbfleisch and Prentice (2002), the individual can test the affect of past experience that firm uses to make their capital structure decisions8 through using the Harvard function h(t) = lim Pr(t = T < t +m| T = t)/m Where as, T is the random variable adjustment in the capital structure of the firm with time. The value of the H knows as Harvard adjustment shows instantaneous rate of adjustment in the capital structure of the firm. This rate shows that with time the capital structure of the firm is changed. Suppose the value of the t = $ showing that firm will change their debt structure in the capital within the first quarter of the year. The Harvard functions9 inform the rate of change in structure of the firm with time while keeping the past experience in view. The real examples of the firms dealing in Europe and Japan shows real examples where the debt rate is higher and thus most of the firms has financing more through their equity than through debt10. The reason is that the firms are facing high cost due to high interest rates. Taxation structure The taxation structure11 of the country highly affects the capital structure in the future. The higher the taxation rate of the country, the firms will emphasis more on the past experience. Moreover, the new firms usually seek the experience of the existing firms to know what their experiences are. For instance, the software and hardware companies are now shifting from United States of America and Canada to India and other south East Asian countries. The reason is that the firm has to pay more on the equity earned through tax rates. Where as, the firm shifting to low tax rate countries to avoid tax income12 and thus this directly effect their capital structure, as these firm will finance more though their equity than through their debt. Conclusion Though, there is not any specific model that can evaluate that either there is any affect of past experience or not but the firm financial reports and capital structure its self is a big evidence showing that the past experience do effect the capital structure of the firm. The past experience on taxation rates and high interest rates affect the firm’s capital structure. Therefore, it is concluded that the firm’s capital structure is affected by the past experience of the firms. Pecking order theory Pecking order theory13 is the hierarchy of financing in which the retained earnings comes first through which firm finances their new projects and business, than followed by debt financing and in last their comes equity financing. The past experience of the firms affected the pecking order theory a lot and thus the hierarchy changes. Usually the firms financing hierarchy mainly depend on the market conditions on which they are earnings. Suppose the market in which they are dealing offers high interest rate on the debt than the firm usually fiancé their new projects with the help of their retained earnings and equity financing. The pecking order hierarchy mainly adopted by the firms that are dealing in neutral market, the market which do not affect the firm’s capital structure of operations. But this condition is not possible as the market the firm dealing in highly affects the firm’s financial and capital structure. Thus, the pecking order theory only work well when the market has low debt rate so that the firm can finance their new project more through debt and less through he equity. Mostly, when the firms adopted pecking order theory in the market having high interest rate than the firms need to evaluate that which project will provide better earnings and which are the poor projects. When the firm is able to evaluate the projects, than in it must internally fiancé the good projects while the poor projects can be financed by the externally using the debts. The good projects when financed internally using the retained earnings than the firm has to pay less on it while the debt is only used by the firms when the firm is running out of the internal finances. Trade-off theory The trade-off theory14 explains that the tax advantages of the debts are trade-off against the threat of bankruptcy. This theory explains that the firms partly fiancé their business with debt and partly with the equity. The partly financing of the firm gives advantages of tax-benefits. Whereas, the firm partly finances their business with the equity bankruptcy and non-bankruptcy cost (staff leaving and supplier demands). The trade-off theory is more used by the firm as they can easily change their capital structure according to the market conditions. The trade-off theory is highly affected by the past experience but the scholars stated that there is no evidence that the trade-off theory is affected by the capital structure. But however, the ratio of equity and debt financing in the capital structure while using the trade-off theory is affected by the past experience. If the firm seeks that the market valuation rate remains high in last few years than the firm will use more equity financing than the debt financing. But however, then trade-off theory do not show any experimental example that shows the directly influence of the past experience as the trade-off theory is mostly affected by the current position of the market. This theory explains the difference in debt/equity ratio’s between the industries but is not able to show this difference in the same industry15. The trade-off theory uses the debt finances until the marginal benefits and marginal cost of the debt equalize each other. When the firm uses this techniques, than the past experience on this have no influence. Marginal cost of debt = marginal benefits of the debt Therefore, above mentioned explanations shows that trade-off theory do not affect by the past experiences of the firm, the weighted average model, the market-to-book ratio and any other capital structure technique do not affect the trade-off theory. The Trade-off theory is only influenced by the current market conditions. Is the interest rate of the debt is high, than the firm uses more equity and retained earnings to finance their business while if the taxation rate is higher than the interest rate then firm will sue more debts and less equity financing. References Garrison Noreen “Managerial Accounting” 10th Edition James Jiambalvo, Rex A. Schildhouse (2000) “Managerial Accounting” Carl S. Warren, James M. Reeve, Philip F. (2005) “Managerial Accounting” Garrison Noreen and Peter C. Brewer (2007) “Managerial Accounting” Lawrence J. Gitman “Managerial Finance” 9th Edition Robert S. Pindyck, Daniel L. 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