Financial Structure Issues - Essay Example

Running head: financial structure Student’s name: Instructor’s name: Subject code: Date of submission: Financial structure: In general, there are two ways in which a firm can choose to finance its assets and the various projects it undertakes. The firm can either finance its assets through issuing of debt or equity. If a firm decides to finance its assets through equity, it may either issue new shares to the existing or new share holders. The Firm may also finance its assets or new projects by the use of retained earnings, which is a part of shareholders equity. On the other hand, if a firm decides to finance its projects through debt, it may either issue short-term or long-term debt. Debt imposes a legal obligation on the company to pay interest. On the other hand, Shareholders get dividends from the firm’s earnings though this is not a legal requirement. The way a firm’s assets are financed i.e.either by long-term debt, short-term debt or equity is its financial structure. Unlike financial structure, capital structure deals with long-term borrowing (debt) and equity entirely. At times, a firm may decide to finance its assets entirely through debt or through equity. However, in many cases, firms combine debt and share holder’s equity in financing their assets. Does the ratio of debt to equity in the firm’s capital structure matter?1 In 1958, Modigliani and miller argued that if corporate taxes were removed, a mixture of debt and equity does not matter. This is due to the fact that the value of a firm is calculated by dividing the operating income by the overall cost of capital.2 On the other hand the overall cost of capital, is the summation of the cost of all the components of the financial structure. This means that the value of the firm does not depend on the capital structure but the cost of capital. This being the case; it may be concluded that the mixture of equity and debt in a firm’s financial structure does not matter. If we are to use a small percentage of debt and a high percentage of equity in the financial structure, the cost of debt will be low. However, this low cost of debt will be offset by the increased cost of equity. Hence, the end result will be the same and the value of the firm will be unaffected. Therefore in a world without taxation, the mixture of debt and equity in a financial structure does not matter.3 If the above argument is to be followed, then the management of a firm would not have to worry about the mixture of the two components of financial structure. Decisions on the composition of the financial structure would not matter so much since they do not determine the firm’s value. However, in the present scenario, management is usually concerned with debt policy. This is why different firms have different debt patterns. The argument that the value of the value of the firm is constant despite the composition of debt and equity does not hold. This is because all the world economies impose various types of taxes to business profits. With the introduction of taxes, the value of the firm changes as the composition of equity debt ratio changes in the firm’s financial structure.4 As stated earlier, debt financing imposes a legal obligation on the firm to pay interest to the providers of debt. The low exempts the interest from being taxed. Therefore, debt financing has a tax advantage to the firm. The more debt a firm uses in financing its assets, the more tax it is exempted from paying. On the other hand, there is no legal obligation on the firm to pay divided to shareholders. Therefore, the dividends paid by the firm are not tax exempt. The implication of this is that the value of the firm that uses debt financing is more than that of the firm that uses equity financing entirely. The value of the firm that uses debt to finance its assets is greater than the value of the firm that uses equity financing entirely. This is caused by the present value of the tax shield. The tax shield is as a result of savings achieved since debt interest is not tax deductible. The tax shield’s present value is given by multiplying tax rate by the amount of debt borrowed i.e. Tc *D. The example below best illustrates how the value of the firm will be affected by debt in a tax regime.5 Suppose firm K has borrowed a loan at an interest rate of 6 percent. The loan amount is 3 million dollars. On the other hand, firm D uses equity to finance its assets. Last year, each of the two firms earned a profit before tax of 1.2 million dollars. Firm D’S equity is capitalized at a rate of 10 percent while the government imposes a tax rate of 34 percent on corporate profits. The value of the levered firm will be 8.94 million dollars while that of the un levered firm will be 7.92 million dollars. This is because of the added tax shield of 34 percent of 3 million dollars. This shows that a firm that uses a bigger percentage of debt financing in its financial structure than equity financing has a higher value than the unlevered firm.6 According to the discussion above, the value of the firm that uses debt capital is equal to that of the un levered firm plus the amount of tax shield due to tax exemption. This implies that more debt in a firm’s financial structure leads to higher value of the firm. Therefore, the management can increase the value of its firm by always increasing the amount of debt borrowed. Eventually, at maximum value, the firm should use maximum debt. However, this is unrealistic in the real world. Firms strive to use moderate debt financing.7 This is because firms must guard themselves against becoming bankrupt and the costs involved. Debt financing also exerts pressure on the firm since it imposes a legal obligation on the firm to pay back the interest and principal. Inability to meet these obligations puts the firm in financial distress. The costs associated with bankruptcy in this case lower the firm’s value. The more levered a firm is, the greater is the risk of liquidation. This also increases the required rate of return by the debt providers. This implies that the optimal mixture of debt to equity in a firm’s finance structure is achieved where the gain from debt equals to the loss expected if the firm is liquidated.8 Though the mixture of debt and equity does not have an effect on the firm’s value, it has an impact on the control of a firm. The decision to use debt or capital will depend on the effect that these methods will have on the firm’s control. The decision to use debt will depend on whether the debt providers will want to have an influence on the projects financed with their money. Suppose that a project is fully financed by debt. Suppose also that the debt agreement provides for the debt providers to have a say in the management of the project. If the project fails to perform well, the debt provider may call for its closure. The debt providers may also demand that their debt be converted into shares hence gaining control over the firm.9 This might not be the initial aim of the firm owners. Sometimes, the management may decide to use debt financing so as to retain their influence in management. This is because issuing new shares will dilute the initial shareholders control and influence over the firm’s management. Debt financing does not dilute ownership of the firm since the debt will eventually be cleared. Therefore, it remains the best option for a firm that wants to finance its projects without diluting its ownership composition.10 Conclusion: Although the value of the firm is not affected by the mixture of debt equity ratio in a tax-free regime, this can only hold in an ideal world. In the present-day world, there is no economy that is tax free. Therefore, taxes are imposed on the firm’s earnings. Therefore, the ratio of the mixture matters in the present world. For a firm to maximize its value, debt would form the biggest part of its financial structure. However, apart from the value of the firm, firms have to consider other factors in deciding the asset debt mixture in their financial structure. If a firm finances most of its projects using debt, it has to be prepared to fulfill its legal obligation to repay the principal and interest. However, if this does not happen, the firm will face a threat of liquidation. Therefore, firms maintain their borrowed funds at optimal levels in order to minimize the risk of liquidation. The composition of the equity debt ratio in the financial structure also affects the composition of ownership in the firm. Therefore, firms, which do not wish to dilute their ownership and hence control prefer debt financing as opposed to equity financing. This is because debt financing does not affect the composition of ownership of a given firm. Therefore, it is obvious that the composition of equity debt mixture in a firm’s financial structure does matter. Bibliography: Aghion, P. ‘The financial structure of the firm and the problem of control’. http://docs.google.com/viewer?a=v&q=cache:24usMVFYVmYJ:www0.gsb.columbia.edu/faculty/pbolton/PDFS/financia.pdf+Does+the+mixture+of+debt+and+equity+in+a+firm%E2%80%99s+financial+structure+matter%3F+Why%3F&hl=en&pid=bl&srcid=ADGEESg4Rq0sTBWB0hUOZQcRdptxHEAzYSrwsWFtv4Oroi6-uYDtwaTbZmR_57bcKLYA7nLcM1-WqW_U3C8sScj66EjcKRHrDsH0wPPeAoyjeIPVKZX9PNr91A34zHPDclPfUZrhziPf&sig=AHIEtbRdkBTZwc4cZ22eD876hi8fAKbjxw ,2005,(accessed 18 April 2010). Brealey, R. Principles of Corporate Finance. Boston, McGraw-Hill/Irwin, 2008. James, C. Fundamentals of financial management. 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