What Is the Capital Structure - Essay Example

ISSUES IN CORPORATE FINANCE Assessed work Introduction: Capital structure is the combination of equity and debt maintained by a firm. The effects of debt on a firm are that stockholders receive a greater return on their investment as their earnings per share increases. Concurrently the risk of increases, thus the required rate or the rate demanded by investors increases. This is because debt financers have a right to their money before the common stock holders. Interest on debt is deductible from the earnings before taxes and interest (EBIT) and enables tax saving to the firm. Thus this leads to lower taxes and frees more cash to pay out dividends. Thus investors can receive a higher return on their investment. However, debt also leads to higher chance of bankruptcy and may restrict managerial behaviours. Thus the firm becomes more risky and on lower levels of return the earns to stock holders declines. The effects of debt on weighted average cost of capital (WACC) are uncertain. It is known that debt reduces the weighted average cost of capital since debt is cheaper than common equity due to tax saving. But since a higher return is demanded from common stock holders the actual effect is not know. Agency costs as well as financial distress may limit the usage of debt. Distress costs are usually higher for firms with significant intangible assets. The precise identification of a firm's optimal capital structure is impossible. There is also no exact measure for the effects of capital structure of a firm on its cost of capital or on the firm's stock prices. Based on this we can only estimate to an extent only what the optimum capital structure would be. Trade-Off Theory The trade-off theory of leverage is one in which a firm trades off the favourable corporate tax treatments, that are, the benefits of debt financing, against high interest rates and costs of bankruptcies. Thus the firm optimizes the capital structure of the firm and balances the debt and equity in an optimum ratio. The trade off theory in effect realizes that agency costs and financial distress costs do exist and are real; these include costs of bankruptcy, direct costs such as lawyer's fees, court costs, administration expenses, etc. and indirect costs such as short term decision costs and supplier or customer imposed costs. The higher the leverage of the firm the higher are the chances of distress faced by the managers. Thus as the level of debt increases in the firm, the cost of debt also increases. This makes debt more expensive as we take more debt. Similar is the case with equity as the debt level increases in the firm, the return on equity demanded by common stock holders increases. The salient features and implications of the trade-off theory are: 1. Debt becomes less expensive than common or preferred stock as interest paid on it is a deductible expense and thus debt provides tax shelters. However, firms do not use 100% debt since this increases the risk of the firm and thus to reduce costs of bankruptcies. 2. The tax benefits attained from low levels of leverage outweigh the bankruptcy costs but the bankruptcy costs outweigh the tax benefits at high levels of leverage. Thus a balance of the leverage in a firm has to be kept. 3. Nonetheless optimal capital structures do exist that can balance the benefits of tax shelters attained from leverage against its bankruptcy costs. The method adopted to minimize the weighted average cost of capital is as follows: The cost of debt and the cost of equity is evaluated at different levels or ratios of debt. Based on this a weighted average cost of capital (WACC) is calculated by assigning market value of capital and market value of debt. This then gives the point where WACC can be minimized. This point is the optimum capital structure. Agency Costs of Free Cash Flow Jensen explains that excess cash flow is the excess cash flow over the required to fund all projects with a positive net present value. Thus essentially free cash flow is the cash flow available for dividend payout. This free cash flow splits into dividends and retained earnings based on the retention rate. When there is a significant amount of free cash flow available, there may arise a conflict of interest between managers and shareholders over the dividend payout ratios and policies. The major problem occurs in motivating managers not to use the free cash flows in projects below the cost of capital or investing this free cash flow in organisational inefficiencies. Debt creation effectively bonds the managers for cash outflows. Thus debt can substitute dividends. This removes the agency problem where managers tend to try and keep a low payout ratio, since with debt the outflows are compulsory. This also reduces the cash flow available for managers. Jensen says that managers may issue bonds in exchange of stock and promise interest and principle payments in the future. Therefore by shrinking the cash available to the manager's discretion, the agency costs would be reduced by way of debt. This also increases the efficiency of the firm as a very real threat of court cases exists in case of non payment of interests and principal amounts. Another advantage of stock buybacks using debt is that it provides tax benefits or tax savings. Thus the weighted average cost of capital decreases. The point where the leveraged capital structure of the firm is optimal would be where the marginal costs associated with debt would be equal to the marginal benefits derived from it. Here the firm's value would be maximized and the debt-equity ratio of the firm would be optimal. As explained earlier, the trade-off theory of leverage helps a firm trade off tax shields against high interest rates and costs of bankruptcies. It realizes agency costs as well as financial distress costs. Higher leverages may lead to higher financial distress for managers but at the optimal debt-equity ratio, the value of the firm would be maximized leading to high stock prices. As Jensen notes that debt may actually reduce agency costs and increase the efficiency of the firm, he is indeed in accordance with the trade-off theory which may be modified to adjust to this additional benefit of satisfying the bondholders now with additional interests and promised principle repayments. RailAmerica, Inc. (NYSE:RRA) is a leading railway operator in the United States of America and Canada. Its railroads operate in three provinces of Canada and twenty-six states of the United States of America. It is listed at the New York Stock Exchange. RailAmerica Inc. has no notes payable issues as of 04-11-2006. This is stated in its financial statements. It also shows that RailAmerica Inc. does not payout dividends to the common stockholders. Its cash in hand values are significantly high and may lead to agency costs for the stockholders and the managers. Therefore it is advisable that RailAmerica Inc. follow Jensen's argument for free cash flow and issue notes in exchange for stocks. This would ensure the appropriate usage of the excess free cash and also stockholder/bondholder satisfaction. Unless we know the different costs at different levels of debt we cannot formulate a table and give the optimum debt level to reduce the weighted average cost of capital. Based on that table we should use the capital structure that gives us the minimum weighted average cost of capital. Essentially firms like railway firms have a lot of fixed assets and can take debt at lower rates based on collaterals. Thus such firms tend to increase the level of debt to minimize the cost of capital. The company's free cash flows are high and yet retention rate is also high. This shows that the company is investing into process inefficiencies. These inefficiencies can be reduced or eliminated by buying back stock by taking debt. This will increase the return on equity and will also reduce the agency problem. Brndbyernes Idrtsforening was the second football club in the world to register on a public stock exchange and float its shares. The 2005 annual report for this company shows that no bonds have been issued by this company. Thus the company is entirely equity financed and is an unlevered firm. By increasing the leverage of the firm we can effectively increase the value of the firm by decreasing the weighted average cost of capital. The excess free cash flow may not be very significant in this case. The company however does not pay out dividends and does not have any major projects being a football club. Given that it does not require capital investment and should effectively have a high payout ratio. Even though such a company should be largely equity financed, we should also consider that the company can take a little leverage so as to increase the returns to the investor. Special care needs to be taken regarding the fluctuations of returns and possible financial distress. Thus even though the company should slightly lever itself it should do it carefully. References: 1. Rail America (2006). Annual report and financial statements 2006. Rail America. 2. Brndbyernes Idrtsforening (2006). Annual report and financial statements 2006. Brndbyernes Idrtsforening. 3. Brealey, R.A., S.C. Myers and F. Allen, Corporate Finance, 8th Edition, McGraw-Hill 4. Jensen, M.C., 1986, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, Vol. 26 Read More