Capital Structure of the BHP Billiton Company - Essay Example

Corporate finance: capital structure Student’s name: Institution’s name: ABSTRACT: Corporate finance and capital structure is defined to give the reader an understanding to the issues addressed concerning the BHP Billiton Company. The issues are concerning the proposed demerger of the South32 Company from the mother company BHP Billiton. Furthermore concepts and theories have been explained to give a scope in the understanding of the demerger as well as the dynamics involved in why it was proposed. The paper looks into the stakeholders and the management aspect of the BHP Billiton Company as well as critiques some of the related searches about the corporate finance. INTRODUCTION: Capital structure explains how a company looks for various ways to fund its operations as well as cover its future growth plans (Arellano & Bond, 1991). It prepares the company to plan a head on how they can manage themselves during times of recession or depression of an economy. The structure is made up of mainly two components that is equity and debt capital. (Anderson, 1981) The trick for corporate management here is to wisely balance the two sources of capital or fore go one depending on the company’s added advantage on the financing issues. Equity capital refers to the hard earned money contributed by the shareholders of the company which consists in two forms (Arellano & Bover, 1995). That is, the initial money invested in the business in exchange of ownership and ploughed back profits which in the past years would have been used to strengthen the expansion or balance sheet in other words retained earnings. (Arellano, 2001) It is said that it is the most expensive form of capital because its cost is actually the return of the company. Debt capital is the borrowed money by the company that is actually in operation in the company’s business activities (Arellano & Honore, 2001). They are divided into long and short term debt capital. Bonds is an example of the long term debt capital which is considered as the safest because the company will have many years to pay the principal while in the mean time they only pay the interest. A short term debt capital example is the commercial paper which is known to be the most unsecured. (Fama & French, 2002). Generally the debt capital gives results when the health of the company is determined through its balance sheets where the managers can know which the appropriate debt capital to be chosen is. Corporate finance is the area of study that deals with corporation’s sources of funding and their capital structure. It also incorporates the managers of the corporations where by they ensure the value of the firm, as well as the tools & analysis involved in financial resources are increased. (Bistrova, Lace & Peleckiene, 2011)The maximization of the firms’ value is the main agenda always in the corporate finance. The finance has three fundamental principles which are investment, financing and dividend principles. The investment principle states that the business should invest in assets and projects that have a higher rate of return than the minimum acceptable hurdle rate. For projects with high risks there should be a higher hurdle rate as well as reflect its financing mix. Financing principle refers to the firm management choosing a financial mix- debt and equity – which will maximize the firms’ investments made. (Bevan & Danbolt, 2002)The dividend principle states that the business should return its cash to the owners if the investments earned are below the hurdle rate. The form of return is through dividends or stock buybacks. BHP Billiton is the leading world’s global resource company. The resources they produce are such as aluminum, coal, copper, uranium etc. and also have ventured into gas and oil. The company has diversified its portfolio to so many assets and that is their defining attribute. The firm is a dual listed company constituting of BHP Billiton Limited and BHP Billiton Plc. The merger of the two companies was concluded on 29th June 2001. Their global headquarters is located in Melbourne, Australia although BHP Billiton Plc is located in London, United Kingdom. The company BHP Billiton is run by one management team with shareholders of both merged entities having equal economic and voting rights. The company has proposed a demerger whereby they want to simplify its existing portfolio by creating an independent company. South 32 is the proposed demerger company; the plan is to turn it to be their global metals and mining company. The board of BHP Billiton recommends its shareholders to support their decision of the demerger by voting for in favor of its approval. The rationale behind it is to maximize the shareholders value and simplify the BHP Billiton portfolio assets. In spite of the advantages that the demerger brings there is the obvious exposure of risks and disadvantages that may come along. The problem is that no one is sure of the exact results the demerger will bring in the future earnings of the firms involved because of the unpredictable global economic conditions as well as other volatile investment decisions of the firms. To address this issue a proper analysis should be done to determine whether the proposal is worth undertaking by the BHP Billiton Company. LITERATURE REVIEW: Demerger is moreover the opposite of a merger; it is the splitting up of an existing company into one or more companies that will operate independently from the mother company. The shareholders from the mother company are usually given equivalent stake of ownership to the new company. (Anderson, 1981) Demergers help in a more relaxed operation of the company on one specific area from its diversified portfolio. A demerger can be described as a spin- off or carve- outs. A spin- off is whereby the shares of the shareholders from the original company get to be distributed in the new company. For a carve-outs the shares in the new company are offered to the public not to the original company shareholders.( Bistrova, Lace & Peleckiene, 2011) The demerger if it becomes successful it will allow the companies have target strategies for its diversified portfolio assets although it will mean that BHP Billiton and South32 will both have less diversified assets than when they were just one company. For the shareholders from BHP Billiton they will have a greater advantage in investment options and at the same time be able to level their investment in BHP Billiton and South32. As much as that will be possible not all the shareholders will be qualified to attain or be able to retain the shares in South32. In addition the demerger will reduce costs of the BHP Billiton because it would not need to cater for South32 operational costs but for the demerger to be implemented there will be costs considered by the mother company. Once the South32 Company is standing alone it will be able to create a model for its operation that is relevant to its core business. During the demerger South32 will incur additional costs as a consequence unlike when it was part of the BHP Billiton Company. South32 will have more opportunities after the demerger in looking for investment options although it will be smaller in size than when it was part of BHP Billiton. Another advantage is that for investors there will be awareness and evaluation enhancement for them as separate companies whereby it will boost both their markets. Similarly there may be taxation implications after the demerger. Having mentioned the above advantages and disadvantages of the BHP Billiton demerger it is wise that we also look as some of the corporate finance theories and concepts that will shed more light to why the company management come up with such decision. Trading-off theory: The theory gives the idea to the firm on how much equity and debt finance should be used in consideration of balancing the costs and benefits. It gives a glance on what corporate finance choices a firm experiences. It deals with two concepts that are financial distress and agency costs. (Arellano, 2001) The theory’s purpose is to clearly explain that corporations usually are financed partly with debt and partly with equity. It favors more the option of having more debt because of the tax relief right that comes with it. Modigliani and Miller are two people who gave the new definition of trading off today. They introduced the tax benefit of debt where the debt decreased with personal tax on the interest income. (Flannery & Rangan, 2006) In the financial distress concept which refers to the in ability of the firm to pay up its debt the theory of the capital structure considers the cost of debt as the financial distress costs/ bankruptcy. The agency cost theory refers to the conflicts between the firms’ management, debt holders and shareholders which bring agency problems. The trade off theory helps give a more accurate and reflective predictions of the agency theory. (Anderson, 1981) It is important for the company managers of both South32 and BHP Billiton Companies evaluate and analyze their company’s financial mix in relation to the trade off theory which helps in reducing the financing cost to some reasonable extent as well as help in maintaining peace between all stakeholders involved. Pecking order theory: The theory helps in defining the capital structure as well as the process of business financial decision making. It was founded by Nicola Majluf and Stewart C. Myers with the intention of seeking how a company can prioritize their financing sources. The theory encourages the businesses first to use their internal funding resources i.e savings if it is not enough to keep the company running turn to lenders or investors and finally if that does not work the business can choose to use its equity. (Myers, 1984) It distinguishes between internal and external sources of finance and gives a certain hierarchy on how to use the various resources with the intention of cutting cost. Market timing theory: It refers to strategically planning on what decisions to make in issues concerning buying and selling of financial assets- often stocks- by forecasting on the future market price movements. The predictions are guided by the economic or market conditions resulting from technical or just important analysis (Bevan & Danbolt, 2002). Some authors say that the pecking order, market timing and inertia theories of capital structure show that managers do not see any big leverage effect on the firms’ value thus they do not work to change the current leverage (Bharath et al., 2009). This is not true because the trade off theory indicates there is linkage between firm value and leverage which is caused by generation of market imperfections. (Bevan & Danbolt, 2002)A regression model is used to test for trade off leverage behavior which requires partial adjustment towards the target leverage ratio that is dependent on the firms’ behavior. (Farma and French, 2002)Using the model trade off theory predicts that underleveraged firms should issue debt or by retiring equity in order to reach their leverage target unlike pecking order theory which contradicts by saying that the firm should ‘stock pile’ their debts by using the excess cash available to retire the outstanding debt. (Jensen, Michael & Long, 1978) On the effects of market performance and profitability the trade off theory states that as long as the costs of adjusting debt ratios exceed the costs of having suboptimal capitals structure the firms’ let their debt ratios deviate from the target while passively accumulating earnings and losses. (Fischer, Heinkel, and Zechner, 1989) Checking on the pecking order hypothesis on the same issue it address to the firms’ managers to issue equity during the periods with high market performance thus implying debt ratios will decline with market performance.( Lucas and McDonald, 1990) For the market timing hypothesis it is similar to the pecking order but makes no predictions on the market profitability. The management of the firm plays a vital role in the running of its activities. Managers are said to take advantage of the valuations of their company assets that result to misevaluation. It has been known that managers in value firms aggressively purchase equity in their employers though it is almost impossible to reconcile with the fact that value managers agree with the market valuation of their firms and even suggests that they still view their firms as undervalued. (Anderson, 1981) Furthermore the managers also view low valuation firms as temporarily undervalued thus being reluctant to sell and often even decide to purchase additional shares. (Arellano, 2001) Growth firms are taken to be overvalued and most managers sell them at first opportunity giving them a lieu way to diversification. In our case of BHP Billiton Company and its demerger with South32 its managers are facing similar situations as mentioned above and even more due to the managerial behaviors of the corporate finance world. It is true that managers do take advantage of the perceived mispricing of the related firm’s valuation levels; however it is difficult to prove the scenario. Facts on changing investment opportunities, changing liquidity and signaling stories of the managers give a glance that account to the various observations of the patterns explaining the management behavior.( Bistrova, Lace & Peleckiene, 2011) If a model can be developed to monitor the optimal equity incentives of managers’ change with valuation levels, it would have low valuation firm managers be forcefully driven to increase their equity incentives through purchases while the high valuation firm managers would be allowed vice versa their equity incentives through sales. CONCLUSION: In relation to the BHP Billiton Company and South32 Company demerger the mentioned corporate finance theories, concepts and models show how they were able to come up with the decision. They have been able to shed some light on the analysis to be used in determining whether the demerger was necessary. The BHP Billiton Company has given advantages and disadvantages of the proposed demerger and together with the capital structure theories and concepts explain to the shareholders the importance of the new initiative of the company. The corporate finance studies help firms to make sound decisions on both managerial and financial issues. For the case study of the BHP Billiton Company it clearly explains how before coming up with the demerger of the South32 Company carried a proper study using the corporate finance studies to conclude on the matter. As for me I support the demerger because I believe they took in consideration all the corporate financial aspect of the BHP Billiton Company analysis thus had the best interest of maximizing the firms’ profits even if it will be experienced in the long run. REFERENCES: Anderson, T., Hsiao, C., 1981. Estimation of dynamic models with error components. Journal of the American Statistical Association 76, 598–606. Arellano, M., Bond, S., 1991. 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