GDP Growth within Corporate Finance Principles - Essay Example

In today's economic climate, any company that hasn't borrowed as much as it can is crazy Introduction Economic growth of a country depends upon its GDP growth. GDP is an indicator of a country's production of goods and services. Finance (capital) a scarce factor of production is required by firms at the highest possible level to maximize production. All over the world, of late, countries follow the pattern of consumption economy wherein consumption is encouraged by giving out loans to consumers for purchase of goods, services and even homes.. This in turn leads to spurt in volume of production of goods and services at all levels to cope which firms need funds for working capital and capital expenditures. However there has been always this controversy of whether a company can borrow at all instead of sourcing the required funds through equity capital. This paper seeks to enquire how far the title of this essay "In today's economic climate, any company that hasn't borrowed as much as it can is crazy" is relevant within the context of corporate finance principles. That is, when business opportunities abound, is it wise on the part of the firms to watch as silent spectators without grabbing them and execute them by means of borrowed capital. The title raises two hypotheses, debt is preferred to equity and in spite of sufficient equity available, a company should borrow maximum possible in the pretext of the resultant economic climate of liberal consumption. First Principles of corporate finance Firms should invest money only if the project earns more than the hurdle rate which is generally higher in projects with high risks and investment pattern will be reflected in the ratio of financing mix of equity and debt. Cash flows and their timing determine rate of return on projects. If there are no profitable investments available, the stock holders' funds must be returned to them. Objective behind these principles is maximising the value of the firm as per the traditional theory of corporate finance. While this is a broader objective, a narrower one can be maximising value of stockholder by which he is enabled to command maximum stock price in the market. In choosing the ideal product mix of equity and debt, the following advantages and disadvantages must be taken into consideration. Borrowing facilitates availing of tax benefit and it is higher in case of higher tax rate. It creates a disciplining environment by which greater separation between management and stock holder is achieved which is a greater benefit as per the principles of corporate governance. Disadvantages are firms are exposed to bankruptcy cost due to higher business risk, agency cost due to greater separation stock holders and lenders and financing flexibility for the future is lost because of greater uncertainty regarding future financing requirements. A debt carries with it a commitment to make future payments which are tax deductible and future defaults in payments can result in loss of control to the lenders. In a hypothetical situation of no taxes (tax free), no separation between managers and stockholders, no default probability, and presence of certainty in future funds requirements, default risk, agency cost and capital structure become irrelevant and firm value is divested of its debt ratio as posited by the Miller-Modigliani theorem. According to this theorem, firm value will be decided by cash flows and there will be no question of leverage. (Damodaran) Real options In the present economic scenario of mergers and acquisitions for bailing out weak firms or as an exercise of creating a competitive advantage, companies require large volume of funds and committed bank facilities are useful in financing their real options to carry out M & A transactions. In 2000, Bank of America advanced bridge loan to Club Corp for debt acquisition as part of M & A exercise. Similarly Bank of America provided Ferrellgas a bridge loan of $ 175 million to carry out acquisition of Thermogas. (Patrick C 2000) Debt-to-Equity Ratio This is the ratio of a corporate's total debt to its total equity. As long as the ratio is 3:1 or lesser, lenders do not hesitate to advance loans to the corporates. But this is unique and ratios are standardised for each industry. For example Banking and real estate industry have higher than 3:1 ratio of debt to equity which is considered normal. (Minassian) Cost of equity v Cost of debt Economic value of the firm is positively associated with its financial performance as it shows the return on invested capital in excess of cost of investing it. Cost of equity capital is in general negatively associated with financial performance of a firm because of increased cost of capital pushing up the hurdle rate to realise economic value creation and is also correlated to increased financial risks because of which it becomes more difficult to show positive financial results. So also leverage is negatively correlated to financial results as it is the assumption that if a firm is losing, it has not infused additional equity. Borrowed capital on the other hand is less costly than equity capital because when the firm restructures its capital structure with more of debt, it can result in firm's achieving positive economic value creation. (Carton B et al 2007s p 203) Because of inherent safety in debt financing, companies resort to market borrowings in the form of bonds rather than equity under the present economic climate. Questar raised $ 250 million from bonds to finance its drilling operations for natural gas in the Rocky Mountains. Similarly AT & T, and Cisco Systems and NRG Energy issued bonds and other forms of for laying fibre optic networks from Alaska to Georgia and mergers and acquisitions respectively. Another Salt Lake City based company has issued bonds to meet the energy requirements of nearly 835,000 homes and businesses. The bond offering of more than $ 676 billion issued has had ripple effects in the world economy. The corporate debt is increasing at the rate of eight percent per annum since 2003. (Salas, July 2006) The case of Maruti Udyog Maruti Udyog is a small car manufacturer that came into being in 1983 in India sidelining the only other two cars of Fiat and Ambassador brands ever since India's independence. It ruled the market with its fuel efficient small cars until 1990s. Since liberalisation in India brought in multinationals like Hyundai, Ford and General Motors and domestic Tata Motors, Maruti Udyog's fortunes started falling. Its profit which was Rs 977.3 crores ($ 24.74 million) in 1998 to Rs 784.1 crores in 1999 and went further down to Rs 385.1 crores in 2000 and finally incurred a loss of Rs 269.2 crores in 2001. This was partly because, its debt which was Rs 1,112.1 crores as at 2001 had eaten away substantial portion of its profits. Maruti therefore brought down the debt to Rs 307.3 crores by 2005 by ploughing back of profits without dividend payments and by fresh equity capital in 2003 about Rs 1,736.3 crores. Examining the 11 years financial data of the company, Ahuja L (2007) states that the company's finance strategy should change after it started facing competition from multinationals. To rid itself of the heavy debt, it resorted to equity financing at one stage. But at the present stages he proposes that debt financing of the company will be the most suitable by usual advantages tax deductibility, and the choice to repay the debt any time so that cost savings are made available to the existing shareholders. He says that Maruti at the time of inception had a debt equity ratio of 1:1 with its limited equity capital. As the company grew, its retained earnings reduced its dependency on borrowed capital. And now a mix of debt and equity will keep the cost of capital at a minimum. Suppose its cost of equity capital is 18% and total cost of borrowed capital is 10% and if the corporate tax is 35 % net cost will be only 6.5%. With this, if capital is structured to result in a debt equity ratio of 1:1, the overall cost of capital will be 12.25%. Therefore capital structuring this way has reduced its equity cost from 18 % to 12.25% with the combination of both equity and debt capital. The author further states at this stage debt equity ratio is so low that any large enhancement in the level of borrowings will not raise the financial risk for the company in the near future as long as long as the guideline ratio of debt equity is maintained at 1:1. For those who would raise a question that a cash rich company like Maruti need not borrow at all, the answer is investments in mutual funds need not be diverted for operations as they can serve as a cushion for any future contingency. Conclusion From the above discussion, it becomes clear that a company need not borrow as much as it can unless it is really warranted. There should be a judicious mix of debt and equity in the capital structure so that in times of emergency, the reserves of equity will come to the company's rescue. Without deviating from the first principles of corporate finance, a company can borrow instead resorting to equity in the interests of the existing shareholders whose interests also need to be maximised. It has been seen that too much of equity is equally undesirable as too much of debt. The company can borrow to any extent if there is paucity of equity but in due course it should enhance its equity by ploughing back of profits and restricting dividends until a comfortable debt equity ratio is reached References Ahuja L Narender, 2007 'Decision-case: Maruti Udyog Financing Strategy' Oxford Business and Econmics Conference: June 24-26, 2007 Oxford University, U.K. ISBN: 978-0-9742114-7-3 Carton B Robert, Hofer W.Charles, January 2007 Measuring Organizational Performance: Metrics for Entrepreneurship And Strategic Management Research Edward Elgar Publishing ISBN-13: 9781845426200 Damodaran Aswath "Corporate Finance: Capital Structure and Financing Decisions" Patrick C Steven (2000) BANKING ON REAL OPTIONS Journal of Applied Corporate Finance 13 (2), 108-111. doi:10.1111/j.1745-6622.2000.tb00058.x Minassian Mark, Debt VS Equity Financing Buiness law/Taxes: U.S. www.about.com.accessed 1 November 2007 Salas, Caroline."U.S. companies borrow to expand; Capital markets show increasing optimism."International Herald Tribune.July 6, 2006 Read More