Chapter 3: Capital Structure

Introduction

Firms are established to produce and sell goods (services) to generate income. Firms use a mixture of debt and equity for raising the required funds to invest. As a broad definition, we can say that the debt and equity mix is called the capital structure of a firm.

Assessing the target capital structure requires an appraisal of the financing sources, the evaluation of their risk, the examination of the maturity-cost relation of debt and the estimation of the cost of equity for different capital budget amounts.

Debt Financing

The possibility of financial distress is positively linked to the debt ratio. Creditors require higher interest rates to lend, because of rising bankruptcy risk. Consequently, the before-tax cost of debt (kd) rises to an extent which balances out the tax benefits.

After-tax kD=kD*(1-T)

The cost of the funds raised by the company, no matter debt or equity upsurge, raises the weighted average cost of capital (WACC). The WACC is the average cost of the capital mix.

WACC=wD*kD*(1-T)+wE*kE

The last but not least, the value of the firm declines as the bankruptcy risk rises since the free cash flows (FCF) drop with the loss of confidence in the firm. The contraction in the accounts payable forces the company to invest more in the net working capital. Consequently, both the FCF and the value of the firm decrease.

Value of the Firm= ∑∞ t=1 FCFt /(1+WACC)t

In the above equation, wD is the weight of debt capital in financing the assets, whereas kD shows the before-tax cost of debt. T denotes the tax rate and when kD is multiplied by (1-T), the after-tax cost of debt is computed. The second part of the equation is the product of the cost of equity (kD) and the weight of equity financing (wE).

Another problem that is caused by the rising bankruptcy risk is the underinvestment in positive NPV projects.

Equity Financing

Equity financing is more expensive than debt financing. Also, as more debt is raised, the risk borne by the shareholder’s increases, leading to a higher cost of equity.

Rather than borrowing and paying fixed interest costs, if managers are preferring new stock issue, it can be taken as a sign that lower earnings and cash flows are foreseen.

Business Risk

The business risk is related to the uncertainty in the business operations of the firm. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, the overall economic conditions and etc.

The fluctuations in the economy change the market conditions rapidly and firms may stay behind in adjusting their forecasts. The return on invested capital (ROIC) measures the operating profitability on capital investments.

ROIC=NOPAT/Capital=EBIT*(1-T)/Capital

• The main factors affecting the business risk of a firm are as follows:
• Higher volatility of demand for the products/services of the firm escalates the business risk.
• Fluctuations in the sales price due to market volatility.
• Changes in input costs.
• The cost structure of the company, especially the level of the fixed costs in total costs.
• The ability to adapt cost-effective measures to changes in both the input costs and output prices.

Financial Risk

Financial risk is the additional risk borne by the stockholders when the company raises debt financing. Financial leverage is an indicator of financial risk and occurs in case of borrowing.

Managers have to work out for an optimal capital structure by harmonizing the advantages and disadvantages related to both types of financing. The optimal capital structure is the mix of debt and equity that maximizes the value of the firm. If the value of the firm is maximized, then the stockholders’ wealth is also maximized.

Capital Structure Theories

In an attempt to find the best practice in attaining this goal, academicians brought up a number of theoretical models. These theories are as follows:

Net Income Approach

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. Both the cost of debt and equity remain constant no matter how heavily debt capital is induced to the capital structure of the firm. The net income approach ignores the rising bankruptcy risk at higher leverage.

Net Operating Income Approach

The model assumes that the cost of debt, the WACC and the value of the firm is irrespective of financial leverage. The value of the firm is its net operating income which is also independent of leverage, capitalized at the constant WACC. The cost of equity rises relative to the increase in leverage, but the rise in the cost of equity is offset by the lower cost on the borrowings. Net operating income approach ignores the fact that the cost of debt increases at higher levels of leverage as creditors’ risk rises.

Traditional Approach

A traditional approach is an intermediate model, compromising between the net income approach and the net operating income approach. Traditional approach assumes an optimal capital structure where the WACC is minimized and the value of the firm is maximized. The cost of debt remains constant more or less up to a certain level, however, above that level, interest rate rises with the increase in the likelihood of financial distress.

Modigliani and Miller Capital Structure Theory

It is one of the most influential studies in academia. MM substantiate that the capital structure of a firm has no effect on its value in a market where the above assumptions hold true. The value of the firm is the capitalized value of its operating income at its average cost of capital.

According to their model, in a world of perfect capital markets, capital structure decisions are irrelevant in determining the value of the firm.

Trade-Off Theory

Financial distress or bankruptcy costs refrain firms from abundant debt financing. Especially firms with higher business risk should rely less on debt financing.

The trade-off theory of leverage suggests that firms trade off the benefits of debt financing against the costs of financial distress and bankruptcy.

Signaling Theory

According to the signaling theory, managerial discretion may convey signals to outside investors other than the decisions on the surface.

The implications of asymmetric information on the capital structure may induce the firm to use less debt in normal times and maintain a reserve borrowing capacity to allow for investments in prosperous projects as they come along

Moreover, the presence of asymmetric information may motivate managers to follow a pecking order in raising funds.

Agency Theory

Agency theory suggests that agency problems may arise if managers (agents) pursue different objectives other than those of the shareholders (principals).

High levels of debt financing bonds the cash flows lessening the effects of agency conflict on the value of the firm. But on the other hand, heavy reliance on debt financing may lead to the underinvestment problem, whereby managers reject risky positive NPV projects constrained by the possibility of financial distress.

The Estimation of the Optimal Capital Structure

At the optimal capital structure, the average cost of capital is minimized, thus the firm value is maximized. Estimating the optimal capital structure requires a careful analysis with repetitions. The managers normally start with a trial capital structure and evaluate shareholders’ wealth. At each trial, the cost of debt and equity are projected in order to quantify the WACC. Then the forecasted free cash flows are capitalized at the calculated WACC to determine the firm value. As a final step, debt is deducted from the value of the firm to measure the value of the equity and the stock price.

Other Factors Affecting the Capital Structure

There cannot be a prescribed optimal capital structure for any business because there are many different factors influencing the capital structure decisions. Even for a single company, the optimal capital mix might require variations in the level of financial leverage over time in relation to changing market forces.

Economic Environment

The economic policies of the country where the company is established to determine the market conditions shaping up both the forces of demand and supply. The inflation rate leads to the interest rate. Additionally, foreign exchange rates influence overseas investments and trading.

Industry Specific Factors

The intensity of the industry-wide competition displays a significant effect on capital structure decisions since value maximization is straitened under heavy competition.

Firm-Specific Factors

Each firm has unique features affecting its asset structure, risk appetite, and competitive strength. The firm age, size, and its legal status are among other elements that impact capital structure. Additionally, the performance of the company, its short and long-term solvency, its level of leverage determines its creditworthiness.

For value maximization, a firm has to attain its optimal capital structure. Changes in inflation and interest rate, tax rate differentials, demand fluctuations, and input price volatility may force companies to establish sub-optimal capital structures.