How capital structure affects cost of capital for UK companies

Abstract

Firms require a reasonable capital structure to meet the required target. To raise the finance, firms normally choose to review some different factors that are taken into account in considering.

In this study, the author will examine the correlation between capital structure and the cost of the capital. As the cost will be a main factor for the firms to raise the finance. And different of capital structure will cause variable cost.

This report will review the literature in capital structure and cost of finance. Along with the availability of source of finance, including the matching principle, a famous tools “trade-off theory�. As well as the argument follows, pecking order theory and agency cost theory.

Drawing a conclusion based on the research survey data collection. Justify the relationship in how capital structure affects capital cost.

Key word:

Capital structure, finance, cost of capital, UK

Introduction

The term capital structure refers to the mix of different types of funds which a company uses to finance its activities. Capital structure varies greatly from one company to another. For example, some companies are financed mainly by shareholders’ funds whereas others make much greater use of borrowings.

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Since the seminal publication of Modigliani and Miller (1958), corporate finance researchers have devoted considerable effort to investigating capital structure decisions (e.g. Myers, 1977 and 1984). Significant progress has been made in understanding the determinants of corporate capital structure with an increased emphasis on financial contracting theory (for example, Barclay and Smith, 1995; Mehran et al., 1999; and Graham et al., 1998 and, for an international view, Rajan and Zingales, 1995). This theory suggests that firm characteristics such as risk and investment opportunity set affect contracting costs. In turn, these costs impact on the choice between alternative forms of finance such as debt and equity, and between different classes of fixed-claim finance such as debt and leasing.

The author will examine the relationship between the cost of capital and the structure of capital, and the effect of cost to raise finance in terms of making financial decision in the firms.

Literature review

2.1 Theory of capital

The origins of capital structure theory lie in the models of optimal capital structure that were developed in the wake of the famous Modigliani–Miller irrelevance theorem. These models later became to be known as the static trade-off theory (see e.g. Modigliani and Miller, 1958, 1963; Baxter, 1967; Gordon, 1971; Kraus and Litzenberger, 1973; Scott, 1976; Kim, 1978; Vinso, 1979). In this theory, the combination of leverage related costs (associated with e.g. bankruptcy and agency relations) and a tax advantage of debt produces an optimal capital structure at less than a 100% debt financing, as the tax advantage is traded off against the likelihood of incurring the costs. This theoretical result is now widely accepted in the profession.

However, in seeking to model the wide diversity of capital structure practice, a number of additional factors have been proposed in the literature.

2.2 Factors that affect capital structure

First, the use of debt finance can reduce agency costs between managers and shareholders by increasing the managers’ share of equity (Jensen and Meekling, 1976) and by reducing the “free� cash available for managers’ personal benefits (Jensen, 1986).

Second, Myers and Majluf (1984) argue that, under asymmetric information, equity may be mispriced by the market. If firms finance new projects by issuing more equity, under pricing may cause les profit for existing shareholders in terms of the project NPV. Myers (1984) refers to this as pecking order theory of capital structure. The underinvestment can be reduced by financing the mispriced equity by the market. Internal funds involve no undervaluation and even debt that is not too risky will be preferred to equity. If external finance was required, firms tended first to issue the safest security, debt, and only issued equity as a last resort.

Under this model, there is no well-define target mix of debt and equity finance. Each firm’s observed debt ratio reflects its cumulative requirements for external finance. Generally, profitable firms will borrow less because they can rely on internal resources and retain earnings. The preference for internal equity implies that firms will use less debt than suggested by the trade-off theory.

Other factors that have been invoked to help explain the diversity of capital structures include: management behaviour (Williamson, 1988), firm-stakeholder interaction (Grinblatt and Titman, 1998), and corporate control issues (Harris and Raviv, 1988 and 1991).

2.3 How to finance

The conventional discussion on a firm’s choice between long-term and short-term debt has generally focused on three aspects: matching debt maturity with asset life; extending the term-to-maturity of loans to stretch the firm’s debt capacity; and concentrating long-term debt issues in periods of relatively low interest rates. Recent development in the financial research literature has advanced several economics concepts such as transaction and agency costs, tax-timing option, and information asymmetry, to the debt maturity choice paradigm.

Brick and Ravid (1985) show that taxes can also imply an optimal debt maturity structure. Depending on the term-structure of interest rates, long-term (short-term) is optimal, since it accelerates the tax benefit of debt given an increasing (decreasing) term structure.

When firms cannot reveal the true quality of their cash flows, i.e. when information asymmetry exists, they can prevent or abate undervaluation by using a variety of signalling devices, such as debt (leverage), dividend payments or the maturity structure of debt. Thus, information asymmetry gives firms an incentive to signal their quality and credibility by taking on more debt and shortening their debt maturity. A higher leverage, especially more short-term debt, signals favourable inside information to the market because it offers the possibility to renegotiate terms in the future, when more information has become available. Long-term debt entails higher information costs than short-term debt, because the market expects a stronger deterioration of quality than insiders do. Firms with a low level of information asymmetry are therefore more likely to issue long-term debt (Flannery, 1986).

In the study of international capital structures, Rajan and Zingales (1995) argue that it is important to test the robustness of US finds in different environments. They identify as potentially important the cross-country differences in tax and bankruptcy codes, in the market for corporate control and in the historical role played by banks and security markets.

Methodology

This survey focuses primarily on the determinants of the capital structure policy of firms but also includes some questions on topics that are closely related to the capital structure. For example, the questions address their approximate cost of equity to the managers, how they estimate their cost of equity (with CAPM or other methods), and whether the impact on the weighted average cost of capital is a consideration in their capital structure choice.

The survey was developed after a careful review of the capital structure literature pertaining to the U.S. and European countries. For ease of comparability, the author tried to keep the format and design the survey similar to that of Graham and Harvey (2001), but modified or simplified some questions that are likely to be relevant in the UK context. For example, literature suggests that there are strong differences in corporate objectives between American and UK financial systems since the former system focuses on maximizing shareholder wealth while the later emphasizes the welfare of all stakeholder including employees, creditors and even he government.

To examine this difference, the author ask the CFOs about the extent to which different stakeholders influence their firm’s financial decisions, the author also ask the firms the percentage of their free float share and whether they have preference or common share.

3.1 Sampling

The initial samples for mailing the survey consist of a total of 57 firms from UK. The choice of initial sample was based on selecting firms that are representative of the UK firms, are widely traded, are comparable across country, and are public limited with available information. These criteria are important to justify the firms’ specific difference. From this sample, 9 firms were deleted because of non-availability of addresses and another 17 firms were deleted because they declined to participate in the survey, leaving a final sample of 31 firms.

The survey was anonymous as this was an important criterion to obtain honest responses. In the mailing a letter was included that was addressed to the CFO or CEO explaining the objective of the study and promising to send a copy of the findings to those who wished to receive. A total of 12 responses were received by mail, which represents a response rate about 38 percent.

3.2 Findings:

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Other characteristics

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3.3 Summary of findings

The respondent firms represent a wide variety of industries with a larger concentration in manufacturing; mining; energy and transportation sector; high technology; and financial sectors. About three forth of firms have a target debt to equity ratios, and about half of these firms maintain a target debt to equity ratios of one. Further, many respondents have a large percentage of their total debt in short term. About 80 percent of respondents report that they calculate their cost of equity, and over 77% of them employ the Capital Asset Pricing Model (CAPM) to calculate this cost. The estimated cost of equity reported by respondents ranges between 9%-15% only few firms report cost of capital greater than 15%

The correlations among the demography variables of this survey are largely as predicted in the literature. These correlations will be discussed in detail in the next section.

Analysis

Three sets of factors in managers’ opinion that are likely to influence capital structure of firms are selected based on a review of literature. The first set is based on the implications of different capital structure theories such as the trade-off theory, the pecking order theory, and the agency cost theory. Generally the managers will make the financial decisions based on theories and through these decisions to affect their cost of capital.

The second set relates to the managers’ timing of debt or equity issues since literature suggests that managers are concerned about financial flexibility. With evidence support in the findings, most of managers within all industries consider the financial flexibility as the most important issue when raise finance. Finance by short term may give the company advantage in changing their status to meet the changing world environment and provide less risks in investments.

Finally, the last set of factors is based on common beliefs among managers about the impact of capital structure changes on financial statements such as the potential impact of equity issue on earnings. This factor shows the important of experience in managers mind and how it will be impact on the decisions.

In summary, to analyse a company’s capital structure, we assume that the company is only financed by two ways, either by shareholders equity or borrowings. It is just to consider how cost of capital affect the different proportion of debt in capital structure.

Figure 8: Two advantages and two disadvantages of borrowing

Advantages

Disadvantages

1. Cheap direct cost because debt is less risky to the investor

1. Financial leverage causes shareholders to increase their cost of capital

2. Cheap direct cost because interest is a tax deductible expense.

2. Bankruptcy risks if borrowings are too high.

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The main advantage of borrowing is that the debt has a cheaper direct cost than equity.

Debt is less risky to the investor than equity (low risk result a low required return)

Interest payments are tax deductable whereas dividends are not.

However, borrowing has two distinct disadvantages. Firstly it causes shareholders to suffer increased volatility of earnings. This is known as financial leverage. The increased volatility to shareholders’ returns resulting from financial leverage causes shareholders to demand a higher rate of return in compensation.

The second disadvantage of borrowing is that if the company borrows too much, it increases its bankruptcy risks. At reasonable levels of gearing this affect will be imperceptible, but it becomes significant for highly geared companies and results in a range of risks and costs which have the effect of increasing the company’s cost of capital.

Limitation and Ethical issue

The research focus on the UK market and respondents are from different areas of industry. The limitation has been carried out. First will be the time of the research. As a three months research, the data was not examined as “correct� enough to support the author’s point. The data collection should be carrying continually in a long period of time and often reviewed at some certain time. Second, the way of collecting these data is limited by mailing. The survey may not represent the whole market as the limited number of respondents. A research should conduct all the possible methods including quantitative and qualitative. Finally, as this is not a professional research, lots of objectives in the research declined to give feedback in judging their financial structure in the case some of this could be their classified information.

The ethical issue has been raised in this research; this will be “honesty� in the feedbacks from the respondents. As this survey is anonymous research, the managers may not give the right information in case of rising threats in competition. The importance of financial structure in firms causes the mangers to think before they actually answer the questions. The privacy issue in their mind raised that they may not want to share all the information regarding to the financial statement.

Conclusion

The purpose of this article is to supplement the existing literature with an analysis of the factors determining the financial structure affecting the cost of capital. The analyses give rise to the following conclusions.

The study presents a dynamic model to address the possibility of adjustment costs incurred in reaching an optimal capital structure. And examine the literature in the factors in capital structure in affecting the cost of financing a firm through the facts in reality.

The conclusion can be drawn as the cost of capital is a key factor that firms taken into account when raise finance along with the financial flexibility. On the other hand, the capital structure of a firm will affect the firm’s cost in both short term and long term. The firms raise the finance to meet the required target, there is no such a way to limit firms’ financial structure. They may want to choose a short term loan to meet flexibility of cash flow, in the contrast; the long term finance may require more information and satisfaction of the firms. The cost of capital depends on how firms finance their capital structure.

Reference and bibliography

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Brick, I. and Ravid, A. (1985) On the relevance of debt maturity structure, Journal of Finance, 40

Flannery, M. (1986) Asymmetric information and risky debt maturity choice, Journal of Finance, 41

Gordon, M. (1971) Towards a theory of financial distress, Journal of Finance, 26

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‘Advantage and disadvantage of borrowing’, available on website www.accaglobal.com, access on 28.04.2010