By Dada Adefolami
The capitalstructure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Also, Financialstructure refers to the specific mixture of long–term debt and equity that a company uses to finance its operations. Like the capital structure, the financialstructure is divided into the amount of the company’s cash flow that goes to creditors and the amount that goes to shareholders
Is it possible to increase shareholder wealth by changing the capital structure?
what is meant by capital structure. The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Some companies could be all-equity-financed and have no debt at all, whilst others could have low levels of equity and high levels of debt. The decision on what mixture of equity and debt capital to have is called the financing decision.
The financing decision has a direct effect on the weighted average cost of capital (WACC). The WACC is the simple weighted average of the cost of equity and the cost of debt. The weightings are in proportion to the market values of equity and debt; therefore, as the proportions of equity and debt vary, so will the WACC. Therefore, the first major point to understand is that, as a company changes its capital structure i.e. varies the mixture of equity and debt finance, it will automatically result in a change in its WACC.
However, before the detail of capital structure theory, we need to consider how the financing decision (i.e. altering the capital structure has anything to do with the overall corporate objective of maximizing shareholder wealth. Given the premise that wealth is the present value of future cash flows discounted at the investors’ required return, the market value of a company is equal to the present value of its future cash flows discounted by its WACC.
Market value of a company = Future cash flows
(perpetuity formula) WACC
It is essential to note that the lower the WACC, the higher the market value of the company – as it was stated from the following simple example; when the WACC is 15%, the market value of the company is 667; and when the WACC falls to 10%, the market value of the company increases to 1,000.
Market value of a company 100 = 667100 = 1,000
0.15 0.10
Hence, if we can change the capital structure to lower the WACC, we can then increase the market value of the company and hence increase shareholder wealth.
Therefore, the search for the optimal capital structure becomes the search for the lowest WACC, because when the WACC is minimized, the value of the company/shareholder wealth is maximized. Therefore, it is the duty of all finance Heads to find the optimal capital structure that will result in the lowest WACC.
Mixture of equity and debt
As the WACC is a simple average between the cost of equity and the cost of debt, one’s instinctive response is to ask which of the two components is the cheaper, and then to have more of the cheap one and less of expensive one, to reduce the average of the two.
the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than equity, the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors. Debt is less risky than equity, as the payment of interest is often a fixed amount and compulsory in nature, and it is paid in priority to the payment of dividends, which are in fact discretionary in nature. Another reason why debt is less risky than equity is in the event of a liquidation, debt holders would receive their capital repayment before shareholders as they are higher in the creditor hierarchy the order in which creditors get repaid, as shareholders are paid out last.
Debt is also cheaper than equity from a company’s perspective is because of the different corporate tax treatment of interest and dividends. In the profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest. However, dividends are subtracted after the tax is calculated; therefore, companies do not get any tax relief on dividends. Therefore, if interest payments are N10m and the tax rate is 30%, the cost to the company is N7m. The fact that interest is tax-deductible is a tremendous advantage.
Back to the mixture of equity and debt will result in the lowest WACC. The natural and obvious response is to gear up by replacing some of the more expensive equity with the cheaper debt to reduce the average, the WACC. However, issuing more debt i.e. increasing gearing, means that more interest is paid out of profits before shareholders can get paid their dividends. The increased interest payment increases the volatility of dividend payments to shareholders, because if the company has a poor year, the increased interest payments must still be paid, which may have an effect the company’s ability to pay dividends. This increase in the volatility of dividend payment to shareholders is also called an increase in the financial risk to shareholders. If the financial risk to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the cost of equity will increase and this will lead to an increase in the WACC.
A firm’s capital structure is the composition or ‘structure’ of its liabilities. For example, a firm that has N20 billion in equity and N80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm’s ratio of debt to total financing, 80% in this example, is referred to as the firm’s leverage.
In summary, when trying to find the lowest WACC, you:
1. Issue more debt to replace expensive equity; this reduces the WACC
2. But more debt also increases the WACC as:
– Gearing
– Financial risk
– Beta equity
– Keg WACC
Remember that Keg is a function of beta equity which includes both business and financial risk, so as financial risk increases, beta equity increases, Keg increases and WACC increases.
The issue is which has the greater effect, the reduction in the WACC caused by having a greater amount of cheaper debt or the increase in the WACC caused by the increase in the financial risk. To this we have to turn to the various theories that have developed over time in relation to this topic.
In financial management, capitalstructuretheory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Competing capitalstructuretheories explore the relationship between debt financing, equity financing and the market value of the firm
The Theories of Capital structure
Which has the greatest effect on the WACC E. G
The reduction in the WACC caused by the Cheaper debt or the increase in WACC caused by the increases
In financial risk and Keg.
1. M + M (No Tax): Cheaper Debt = Increase in Financial Risk / Keg
2. M + M (With Tax): Cheaper Debt > Increase in Financial Risk / Keg
3. Traditional Theory: The WACC is U shaped, ie there is an optimum gearing ratio
4. The Pecking Order: No theorized process; simply the line of least resistance first internally generated funds, then debt and finally new issue of equity
Modigliani and Miller’s no-tax model
In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation, the WACC remains constant at all levels of gearing. As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk. The WACC remains constant at all levels of gearing thus the market value of the company is also constant. Therefore, a company can not reduce its WACC by altering its gearing.
The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. Summary: Benefits of cheaper debt = Increase in Keg due to increasing financial risk. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure exists.
Modigliani and Miller’s and -tax model
In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically. As debt became even cheaper due to the tax relief on interest payments, cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC due to the even cheaper debt is now greater than the increase in the WACC due to the increase in the financial risk/Keg. Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, it should borrow as much as possible.
Summary: Benefits of cheaper debt > Increase in Keg due to increasing financial risk.
Companies should therefore borrow as much as possible. Optimal capital structure is 99.99% debt finance.
Market imperfections
There is clearly a problem with Modigliani and Miller’s with-tax model, because companies’ capital structures are not almost entirely made up of debt. Companies are discouraged from this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to take in account.
Bankruptcy costs
Modigliani and Miller assumed perfect capital markets; therefore, a company would always be able to raise funding and avoid bankruptcy. In the real world, a major disadvantage of a company taking on high levels of debt is that there is a significant possibility of the company defaulting on its increased interest payments and hence being declared bankrupt. If shareholders and debt-holders become concerned about the possibility of bankruptcy risk, they will need to be compensated for this additional risk. Hence, the cost of equity and the cost of debt will increase, WACC will increase and the share price reduces. It is interesting to note that shareholders suffer a higher degree of bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.
If this with-tax model is modified to take into account the existence of bankruptcy risks at high levels of gearing, then an optimal capital structure emerges which is considerably below the 99.99% level of debt previously recommended.
Other costs
Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large companies, the finance providers, the principals are not able to actively manage the company. They employ ‘agents’ managers and it is possible for these agents to act in ways which are not always in the best interest of the equity or debt-holders.
Though we are currently concerned with the issue of debt, we will assume there is no potential conflict of interest between shareholders and the management and that the management’s primary objective is the maximization of shareholder wealth. Therefore, the management may make decisions that benefit the shareholders at the expense of the debt-holders.
Management may raise money from debt-holders stating that the funds are to be invested in a low-risk project, but once they receive the funds they decide to invest in a high risk/high return project. This action could potentially benefit shareholders as they may benefit from the higher returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on company performance. Thus, the debt-holders do not receive a return which compensates them for the level of risk.
To safeguard investments, debt-holders often impose restrictive covenants in the loan agreements that constrain management’s freedom of action. These restrictive covenants may limit how much further debt can be raised, set a target gearing ratio, set a target current ratio, restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the type of activity the company may engage in.
As gearing increases, debt-holders would want to impose more constrains on the management to safeguard their increased investment. Extensive covenants reduce the company’s operating freedom, investment flexibility positive NPV projects may have to be forgone and may lead to a reduction in share price. Management do not like restrictions placed on their freedom of action. Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them.
Structuralleverage, which is leverage that is a strategic part of the fund’s structure and design, intentionally used to create additional systematic long-term investment exposure. It includes Regulatory Leverage.
Finally
The fact that interest is tax-deductible means that as a company gears up, it generally reduces its tax bill. The tax relief on interest is called the tax shield – because as a company gears up, paying more interest, it shields more of its profits from corporate tax. The tax advantage enjoyed by debt over equity means that a company can reduce its WACC and increases its value by substituting debt for equity, providing that interest payments remain tax deductible.
Nevertheless, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief.
This is the point where companies become tax – exhausted, i.e. interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing.
When companies are analyzed, investors often calculate the company’s market value capital structure. This is done primarily by using a ratio called the debt-to-equity ratio. A company’s capital structure is made up of several key items including long-term debt, short-term debt, common equity and preferred equity.
In finance, capital structure is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is the composition or ‘structure’ of its liabilities. For example, a firm that has N20 billion in equity and N80 billion in debt is said to be 20% equity-financed and 80% debt-financed
How to calculate average cost?
An average is the sum of a list of numbers divided by the number of numbers in the list.
Example list:
10, 15, 16, 22, 10, 8, 12, 24, 9, 14
total number of numbers = 10
total sum = 140
average = 140 / 10 = 14
How to calculate cost per unit?
To figure your total manufacturing costperunit, divide your total costs by the total number of units produced. For example, say for the year your company made 1 million units and incurred production costs of N3 million. Divide your N3 million costs by the 1 million units to find your costperunit: N3.
What is the weighted average method?
One advantage of the weighted average method is the simplicity of the calculation to determine the values for ending inventory and cost of goods sold. The company only needs to consider the total beginning inventory value and the current period costs. Alternative methods of product costing include LIFO and FIFO
How to calculate the cost of capital?
The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%
The ending inventory valuation is N45,112 (175 units × N257.78 weighted average cost), while the cost of goods sold valuation is N70,890 (275 units × N257.78 weighted average cost). The sum of these two amounts (less a rounding error) equals the N116,000 total actual cost of all purchases and beginning inventory
The international debtstructure is the way countries finance their spending through a mixture of borrowing and lending. A country can have internal and external debts
Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: surajudada@yahoo.com: 08052043855