# Capital structure analysis

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### Introduction

The importance of a company's capital structure nowadays has become the subject of heated academic debate. In general, there are two sources of capital: debt and equity. Based on Denzil and Antony (2004), it is usually rational to finance any business project with a combination of these two in order to fulfil the changing objectives of the firm. Equity finance represents the highest level of risk due to both uncertainty of dividend payments and capital gains, and the ranking when a company goes into liquidation. While there is no uncertainty of debt finance unless a company is likely to be declared bankruptcy and also debt financing enjoys some tax advantage. However, according to the financial analysis of Jessops (2008), a very high level of dependence on debt finance does not allow the firm to take the advantage of tax benefit, conversely making the firm vulnerable to buyout due to very low payment of dividend that the share holders may no longer be interested in the continuation of the situation and the company faces bankruptcy risk. Therefore, it is very important to determine the proportion of financing through debt and equity respectively.

In this paper, an attempt has been made to examine Wal-Mart's capital structure. It estimates the company's cost of equity and debt as at the latest balance sheet date and contains a description of how the company's capital structure has changed over the three year's data by using the dividend growth model. The analysis and valuation will be supported by graphs, tables and some numerical calculations which showing the financial growth, trends and ratios of Wal-Mart over three year's period. Furthermore, it will explain the reason why the company has adopted the capital structure as identified by the results have been calculated. Besides, the explanation will be based on traditional and modern capital structure theories and some background of the Wal-Mart and the retail industry it operates in.

### Company description

Based on the articles on the official website 'walmartstores.com', Wal-Mart is the world's largest retailer, which operates nearly 8,159 stores and club locations in 14 markets employ more than 2.1 million associates, serving more than 176 million customers a year today. Store types include discount stores, warehouse stores, and mixture of discount and grocery stores. In addition, Wal-Mart also sells its products online through the internet. It continuously offers low prices and a broad range of merchandise. However, it doesn't compete only in discount and clothing, but also in other important categories such as health and beauty products, sporting goods, electronics, as well as toys. The following tables illustrate the financial results of Wal-Mart throughout the period from 2007 to 2009.

Based on the above financial results, it's clear that Wal-Mart is considered a healthy company with steady growth of return. In 2009 financial report, it is obvious that a decrease in the ratio of debt to the total capital primarily due to decreased borrowing levels which results from the current economic environment has made it difficult to receive new financing. But the 2009 financial figure seems favourable. Wal-Mart is still able to keep up the business profitably without considerably decline primarily due to the managers' efforts to control expenses and sell higher margin products allowing it to reduce debt and pay dividends while investing heavily in capital projects. In addition, there is a slight decrease in the increase rate of net sales in FY 2008 and 2009 which mainly results from the unfavourable impact on the foreign currency exchange rates and the global store expansion programs.

### Retail industry development and trends

From the stock analysis of Wal-Mart Stores taken by Dulce et al (2008), a remarkable trend in the retail industry nowadays is consumers buying less and less. Until about a couple years ago, consumers used their credit cards rather than cash to do the shopping. They did not hesitate to add to their already large debts but nowadays because of new policies issued, consumers are trying to pay down debts instead. The price leadership strategy known as "Save money, live better." was implemented in fiscal year 2008 and 2009 aimed at families with children and old people and low- and middle-income consumers trying to save. The company maintains a flexible management style where it is willing to satisfy changing demands of different projects. To meet demand, the company must encourage managers to expand high demand products and delete unpopular product lines that may be a waste of inventory space. Another trend is discounters' development of private trademarks which are distributed and sold only in the retailers' stores.

### Valuation

For the purpose of valuating Wal-Mart, the dividend growth model will be used in this paper which can determine its weighted average cost of capital (WACC). The reason to choose this approach is because Wal-Mart financial features seems fit to its requirements which are the stream of future benefits that rise from holding shares and stable dividend growth rates. However, in order to calculate WACC, the cost of debt and equity should be solved first.

### Cost of debt

In order to calculate the cost of debt, the weighted average effective interest rates of long-term debt and the effective tax rate will be used as quoted at Wal-Mart annual reports from 2007 to 2009. Based on the assumption that loan capital is irredeemable with a fixed interest rate, the cost of debt can be calculated by the formula: Kd=I (1-CT). The data and calculation for the firm's before-and after-tax cost of debt are summarized in Exhibit 1.1.

### Cost of equity

To estimate the cost of equity by using the dividend growth model, which is a simple shareholder valuation model, the assumption is made based on that dividends grow at a constant rate over time. Therefore, the cost of equity can be calculated by the formula as K0= D0 (1+g)/P0 +g, where D0 is the current dividend quoted at annual reports each year and g is the expected growth rate of dividend which is 19.08% calculated by using dividend growth model ($0.67(1+g) 2=$0.95), P0 is the average share price which can be found at annual report each year. The data and calculation for cost of equity are summarized in Exhibit 1.2.

### Weighted average cost of capital

To estimate the weighted average cost of capital, the cost of debt and cost of equity will be used. For the weight of debt, it can be calculated as dividing the total debt reporting in the liabilities section of Wal-Mart balance sheet straightly (since it is difficult to achieve its market value) by the sum of debt and equity. While for the weight of equity, it can be calculated as dividing the equity (which is the total shareholders' equity showed in the balance sheet each year) by the sum of debt and equity. The data and calculations of Wal-Mart's estimated weighted average cost of capital are summarized in Exhibit 1.3 and the graph of financial results displays in Exhibit 1.4.

### The traditional approach to capital structure

The first of views on capital structure is usually called the traditional approach. This view relies on a number of simplifying assumptions which are no taxes exists, the financing choice is between ordinary shares and perpetual debt, capital structure changes incur no costs, all earnings are paid out as dividends, business risk is constant over time so the earnings and dividends are constant. The proposition of the traditional approach to capital structure is that an optimal capital structure does exist and that a company can therefore increase its total value by the sensible use of debt finance within its capital structure. In this case, the cost of equity increases as gearing increases due to rising financial risk and later bankruptcy risk; while the cost of debt rises at high levels of gearing due to bankruptcy risk. As company starts to replace expensive equity with cheaper debt, the weighted average cost of capital (WACC) falls, the cost of debt and equity increase which offsetting the benefit of cheap debt. The following is the graph illustrating the traditional approach.

However, it is clear from the Exhibit 1.4 that Wal-Mart's before-tax WACC is nearly constant from 2007 to 2009 and the cost of debt does not increase each year, so it seems not consistent with the assumptions of traditional approach which concludes that an optimal capital structure exists for individual companies.

### The Miller and Modigliani approach to capital structure (1958)

After the traditional approach to capital structure, Miller and Modigliani (1958) proposed that a company's WACC remains unchanged at all levels of gearing, implying that no optimal capital structure exists for a company. They argued that the market value of company depends on its expected performance and commercial risk by using a model based on the assumptions of the traditional approach, but added the extra assumption that capital markets were perfect which implies that bankruptcy risk could be ignored. The following graph illustrates the Miller and Modigliani approach (1958)

As debt holders do not face bankruptcy risk in the perfect market, the cost of debt (kd) is constant and does not increase at high levels of gearing. However, the cost of equity (ke) increases in order to reflect the higher financial risk faced by shareholders at higher levels of gearing. The company's WACC remains constant at varying levels of borrowing as benefits obtained from raising finance through borrowing exactly offset the increase in returns to ordinary shareholders. Miller and Modigliani therefore state that the WACC of a geared company is identical to the cost of equity (?) of a company if financed entirely by equity. However, this view was later challenged since it ignored effects of the taxation on interest payments.

It can be easily seen from the graph of financial results, the cost of debt is almost constant which represents the bankruptcy risk in Wal-Mart is very low and the cost of equity increases at high levels of gearing over three years which illustrates that when the company finances with more debt shareholders will face more financial risks leading the cost of equity increases, in addition, before-tax WACC remains constant regardless of how much debt in capital structure since that the benefits of using cheaper debt exactly offset the extra cost results from the increase in required returns demanded by shareholders. Therefore, the capital structure of Wal-Mart is consistent with this view.

### The Miller and Modigliani (1963)

Miller and Modigliani (1963) later amended their earlier model by recognizing the existence of corporate tax. They acknowledged the tax relief that a company receives when makes interest payments to debt holders. The tax advantage enjoyed by debt finance over equity finance means that a company's WACC decreases as gearing increases which suggests that the optimal capital structure for a company is 100 percent debt finance and the value of a levered firm is greater than an unlevered firm.

Miller and Modigliani (1963) theory has three propositions. M&M1established that the proportion of debt in the capital structure only affects firm value if taxation is included in the model. M&M2 showed the relationship between the proportion of debt in the capital structure and the value of equity and taxation is considered in this proposition. M&M3 looks how the proportion of debt in the capital structure affects the WACC in a levered firm. In the case of Wal-Mart Stores when the taxation is not considered, before-tax WACC has nearly no change throughout three years representing the value of the firm is almost the same regardless the mixture of debt and equity which is consistent with M&M1. Furthermore, the cost of equity is increasing stably with high level of gearing because of financial risk and bankruptcy risk which is consistent with M&M2. Last but not least, the after-tax WACC also seems constant throughout three years which is not consistent with M&M3. It may be due to the benefits of using debt exactly offset the extra cost in this case regardless it is before-tax or after-tax and the difficulty of obtaining the debt.

In conclusion, the capital structure of Wal-Mart is consistent with the view of Miller and Modigliani except for M&M3. Therefore, the value of the company will keep unchanged in the future no matter how its capital structure changes.

### Conclusion

Besides the dividend growth model valuation, it is clear that Wal-Mart is a very healthy company. Some of the supporting factors are: constant level of the gearing ratio, steady increase of net sales and sound liquidity (3-year current ratio ranges between 0.8 and 0.9). However, there are some problems along with the calculations. Firstly, the data used to estimate are not very accurate, such as the current share price as at each year's balance sheet date, the average dividend growth rate and the value of debt, which may lead to imprecise results. Secondly, due to studying only around a limited time period which causes the findings not very distinct, it will be clearer if around few more years. Last but not least, today's market is not perfect but implies some kinds of risks.

In a word, it appears that by integrating sensible levels of debt into its capital structure a company can enjoy the tax advantages arising from debt finance and thereby reduce its WACC, as long as it does not increase its gearing to levels that give rise to concern among its investors about its possible bankruptcy.

### References:

- Brealey, R.A. and Myers, S.C. (2002), Principles of Corporate Finance. United Kingdom: McGraw Hill Higher Education.
- Dulce C., Nelson D., Tuan P., Bhavik S. (2008), Wal-Mart Stores, Inc. Stock Analysis. Retrieved from: http://testwww.stjohns.edu/download.axd/35f3002c8a2c4fbda7caf13a2bf440e4.pdf?d=Wal-Mart-final-121708
- Denzil W. and Antony H. (2004), Corporate Finance: Principles and Practice. United Kingdom: Financial Times Press.
- Jessops: Financial analysis (2008), retrieved from: http://essayblog.org/dl/samples/FinManagement.pdf
- Miller, M. and Modigliani, F. (1958) 'The cost of capital, corporation finance and the theory of investment', American Economic Review, Vol.48, pp. 261-96.
- Miller, M. and Modigliani, F. (1963) 'Taxes and the cost of capital: a correction', American Economic Review, Vol. 53, pp.433-43.
- Wal-Mart Stores (2009) Annual Report, retrieved from: http://walmartstores.com/sites/AnnualReport/2009/
- Wal-Mart Stores (2008) Annual Report, retrieved from: http://walmartstores.com/sites/AnnualReport/2008/
- Wal-Mart Stores (2007) Annual Report, retrieved from: http://walmartstores.com/sites/AnnualReport/2007/
- Wal-Mart Stores research (2002, May 17th), retrieved from: http://www.yudha.net/research/wmt.pdf