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Question Dear Leo, Thank u for answering the previous question. Kindly answer this: Analyse the capital structure of any company and comment upon the factors influencing the pattern of capital structure.
Answer PRANAB.
HERE IS SOME USEFUL MATERIAL.
REGARDS
LEO LINGHAM
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THE PATTERN OF CAPITAL STRUCTURE VARIES WITH TIME
AND ALSO THE ON THE ATTITUDE OF THE MANAGEMENT
AT THE GIVEN TIME.
The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds. The cost of equity is the return that ordinary stockholders expect to receive from their investment. The cost of loan stock is the rate, which the company must provide its lenders. The weighted average cost of capital (WACC) firm’s capital structure is the average of the cost of its equity, preferred stocks and loan stocks.
An ideal mix of debt, preference stocks and common equity can maximizes the share prices. Debt capital is regarded, as cheap source of finance to the business but will also increase the finance risk of the company. Common stocks regarded as less risky but might lead to loss of voting rights if bought by outsiders.
FACTORS INFLUENCING CAPITAL STRUCTURE
Business risk
Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal capital structure is required.
Tax position
Debt capital is regarded as cheaper because interest payable is deductible for tax purposes. Advantage not much for businesses with unrelieved tax losses, depreciation tax shield as they already have an existing lower tax burden.
Financial flexibility
Depends on how easy a business can arrange finance on reasonable terms under adverse conditions. Flexibility in raising finance will be influenced by the economic environment (availability of savers and interest rates) and the financial position of the business.
Managerial style
How much to borrow also depend on managers approach to finance risk. Conservative managers will usual try to keep the debt equity ratio low.
BUSINESS AND FINANCE RISK
Business risk
The variability in operating income caused but inherent factors of the business other than debt financing. Can be influenced by changes in prices, variability of inputs, sales volume, and competition levels.
Finance risk
Additional variability in return that arises because the financial structure contains debt. Finance risk measured through gearing/leverages ratios.
FINANCIAL GEARING
Extent to which debt finances firms total capital structure
Debt equity ratio: Total debt
Total assets
TIMES INTEREST EARNED
Measures the firm’s ability to meet its annual finance interest payments.
TIE RATIO
= Earnings before interest and tax
Interest charges
OPERATIONAL GEARING
Measures to what extent are fixed costs used in firms operations. Breakeven point analysis will measure the relationship between sales volume, variable cost and the fixed costs. Breakeven point is the level of sales where the firm is neither making profits nor losses i.e. Sales value equals costs.
Financial gearing can reach very high levels, with companies preferring to raise additional capital for expansion by means of loans rather than issuing new equity, but there are limits.
Restrictions on further borrowing might be contained in the denture trust deed for a company’s current debenture stocks in issue.
Occasionally, there might be borrowing restriction in the articles of association.
Lenders might want security for extra loan which the would be borrowers cannot provide.
Lenders might simply be unwilling to lend more to a company with high gearing or low interest cover.
Extra borrowing beyond a safe level will cost more interest. Companies might not be willing to borrow at these rates.
Apart from the limitations stated above, there are other side effects associated with high gearing which may include the following:
Financial distress where obligations to the conditions are not met or they are met with difficulties
Costs: - Loss of key suppliers
Uncertain customers
Low asset value
Loss of staff moral
Legal costs
Agency costs in trying to negotiate additional loan facilities through an agent.
High interest rates
Need to sign loan covenants thereby loosing financial freedom
Borrowing cap
Limits set by lenders on amount available
Financial slack – Highly geared firms fail to seize opportunities as they arise due to unwillingness of lenders for more fund advancements.
High gearing might send bad signals on company’s liquidity to employees as well as lenders
Loss of decision making on certain areas to lenders due to loan covenants
Despite mentioning all the limitations and cost of high gearing mentioned above company’s still uses debt capital. Apart from being cheaper than share capital the following attributes compels the company to use the debt capital.
Motivation – Regarded as cheaper source of income
New issue stocks may dilute holding
Operational and strategic staff more cautious on utilization of funds
Flexibility in arrangement than equity
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“Top management’s risk-taking propensity affects the firm’s capital structure”. The amount of debt
that top managers feel is manageable affects the overall debt ratio of the firm since the
owners most often have to personally guarantee the loan in order to acquire one (Barton &
Matthews, 1989). McMenamin (1999) argue that owners attitude towards risk seem to influence
the choice of capital structure. As debt increases the risk inflate, hence, a riskaverse
organization will probably use debt to a less extent than a risk-willing organization.
This proposal about top management’s risk awareness affecting capital structure is supported
by Levin and Travis (1987) (cited in Barton & Matthews, 1989) who claim that
SMEs’ equity level plays impact of their owners’ attitudes towards risk. In case SMEs need
external financing they will prefer short-term debt before long-term debt since the latter
reduce management’s operability and short-term debt do not include restrictive covenants
“Top management’s goals for the firms will affect the firm’s capital structure”. Not all managers strive
for profit maximizing; growth can sometimes be considered more important .
SMEs do not follow the same patterns and policies as larger
companies do. In fact, SMEs choose debt on personal and managerial preference than
what larger firms are able to do.
Capital structure processes should be analyzed by the impact of owner/manager’s personal
reference and values of the firms’ characteristics.
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“Top management would prefer to finance firm needs from internally generated funds rather than from external
creditors or even new stockholder”. Top mangers have a preference to remain as free as
possible and do not want to become restricted by debt agreements .
BUT this could lead to an under-investment problem where high-quality, lowrisk
project are rejected to be undertaken due to lack of equity and the unwillingness to external
financing.
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“The risk propensity of top management and financial characteristics of the firm affect the amount of debt
lenders are willing to offer and on what terms”. Credit institution’s willingness to lend money to
different organizations is risky from their point of view; they always estimate how well they
consider the organization’s ability to pay back when providing a bank loan
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“Financial characteristics moderate the ability of top management to select a capital structure for the firm”.
The financial risk and flexibility of a firm tend to affect what the management’s willingness
change their capital structure . The main incentive to increase
the level of debt in a firm’s capital structure is when the interest costs are tax deductible
CAPITAL STRUCTURE DECISION IS INFLUENCED BY
Need for control --Risk propensity--Experience--Social norms--Personal net worth
WHICH AFFECTS
VVV
Beliefs about debt
VVV
Attitudes towards debt
VVV
Capital structure decision
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WHICH IS ALSO INFLUENCED BY
External variables
Market conditions
Financial decisions
Organizational form
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4.3.1 The capital structure diagrams
The capital structure consists of
three parts;
Short-Term Debt, Long-Term Debt and Equity.
Below is how the proportional weight of the company’s total capital is calculated.
Short-term debt
Where short-term debt is current liabilities, expiring within one year, including: accounts
payables, current tax-liabilities as well as accrued expenses and deferred revenues
SHORT TERM DEBT %= short term debt / debt+equity
Long-term debt
Long-term debt is the intermediate and long-term liabilities, expiring after one year, such as
bank loans added with 28 % of the untaxed reserves which will be taxed once they are used
for investments
LONG TERM DEBT % = long term debt + .28 [untaxed reserves] / debt + equity]
