The proportion of equity in the total capital of a firm can influence the overall cost of capital and therefore the value and the wealth of the shareholders.
Why do firms borrow capital that has to be repaid rather than finance a firm with 100% equity?
Many different authors have over the past years debated the issue of an optimal capital structure with different methods being put forward. Capital structure is the way firms finance their activities with the mix of different types of funds. For example, some firms are financed by mainly shareholders fund whereby others are financed by borrowing and in some cases a combination of both. If capital structure can affect a firm's value then is there a “golden rule” to obtain an optimal capital structure to maximise firm's value?
It is most likely that when starting up a business, most firms will not be able to come up with all the funding they need, therefore outside help will be needed. When it comes to getting outside help regarding the funding of your business, there are two routes in which a firm could go about it, as mentioned above they are equity and debt financing.
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Debt financing as its name suggest is any money that is borrowed by a firm in order to run its operations. It involves borrowing money from a lender usually banks, with understanding that the full amount will be repaid in the future with interest. This type of financing could either be long term or short term. The money borrowed will have to be re-paid with interest at a future date. Short term debt financing means the debt has to be re-paid say within one year and long term debt is a loan that has to be re-paid after one year. Unlike equity financing the lender does not gain an ownership stake or interest in the business.
The major advantage regarding debt financing is that the lending party does not gain any part of ownership of the business and the only obligation you have to the third party is to repay the debt. In addition, repayment of this is typically a fixed expense, according to the terms of the loan.
The main disadvantage in debt finance is that the business will not have all of its cash flow available to do business. Also, the interest that is owned can be high.
Starting up a business with equity financing would look more appealing source of finance to anyone due to fact that it would feel like you are getting free money during the start-up stage of the business. In other words, it is source of financing without incurring debt, but unfortunately it does require the owner to give up a percentage of ownership stakes in his business to the lender.
There are many sources of equity financing such as non-professional investors, family, friends and many more. However the two most common of equity financing are professional investors known as venture capitalist and business angels. Venture capitalists are investors looking for businesses with potential to grow, whereas business angels are wealthy entities who invest in start-up and growth companies in return for equity in the company.
The most significant advantage of equity finance is that the cash flow that would have been to repay the debt could be used to develop the company.
One considerable disadvantage of equity financing is the loss of interest of ownership of the business and also the possible loss of complete control that can accompany a sharing of the business ownership with investors.
The major breakthrough regarding capital structure came with Franco Modigliani and Merton Miller known as (M&M) proposition in 1958. According to Modigliani-Miller Theorem, “the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends)”.
When M&M looked at whether there was an optimal capital structure, their conclusion was based on a number of assumptions such as, managers were unselfish, debt is risk free and corporate taxes do not exist. Based on their assumptions M&M concluded that the firm value was unaffected by its leverage and that investment and financing decisions could be separated.
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Firstly, M&M looked what effect of differing levels of debt would have on the cost of capital. Since M&M assumed that debt was risk free; it meant that the cost of debt was the same as the risk free rate of the market. Therefore if debt is risk free as believed, M&M implied that the equity holders were the only risk takers because debt holders are always paid first.
Point A shows that there is no sign of debt which means that only equity holders face the business risk of the firm. As the firm becomes more leveraged, equity holders face more and more financial risk as cash flows becomes more unpredictable and it significantly means the cost of equity rises in order to compensate the equity investors for taking on this higher risk. M&M pointed that out considering cost of debt or equity on their own, however, is worthless and the overall cost of capital (measured by the weighted average cost of capital or WACC) is the only measure worth considering, and it is this measure that should be used as the discount rate in valuing the firm. As shown by the graph above, MM showed that in spite of fluctuating cost of debt and cost of equity, WACC would be unaffected by the debt-equity ratio. As V=NCF/WACC, assuming perpetuities, then we can see the value of the firm is also unaffected. In such an environment absent of taxes therefore, MM showed that the capital structure decision becomes irrelevant.
These findings unfortunately, did not prove useful for managers as they could not apply this theory into the real world. Later M&M maintained most of the theory but forfeited the idea that corporate taxes do not exist. Modigliani and Miller showed that capital structure decisions do not affect the firm's value when markets are perfect, corporate taxes do not exist and firm's investment and financing decisions could be separated. Moreover when one or more of M&M assumptions are relaxed many authors demonstrated that changes in debt and equity mix can affect the firm value.
Since Modigliani and Miller had assumed risk free debt, but risk free debt as well as world with no taxes was heavily improbable point of view, a more traditional point of view developed. The traditional view states that when a firm begins to borrow, the advantages it has outnumbers or overshadow the disadvantages. The cheap cost of debt alongside its tax benefits would simply cause the WACC to fall as borrowing rises. Others states that the traditional view is that a firm should combine tax relief with debt capacity when trying to find their optimal capital structure.
On the other hand, as the gearing of the firm rises, the effect of financial leverage means shareholders could start demanding higher required rate of return. At higher gearing, the cost of debt therefore rises because bankruptcy risk of the company also rises. So at higher gearing, the WACC will increase. As shown above, the traditional view believes that the best of find the optimal capital structure of a firm is to trade off the tax benefits of debt and the cost of risky debt to maximise the firm's value. As Fairchild states when BT won the 3G mobile contract, “they may have believed that the increased prospects for the Group had increased their debt capacity”. As a result they wanted to take advantage of the supposed extra tax benefits of debt available and justified increasing debt. BT, however, possibly overestimated the prospects of 3G and increasing debt led to a drop in overall firm value. This suggests BT went beyond their debt capacity, but also suggests that this traditional view of a trade-off between costs and benefits of debt could work if applied properly.
Damodaran (2001) considers the trade-off in greater depth and argues that firms should determine their optimal structure by trading off the cost and benefits of debt. He summed up that debt provides two main benefits (tax benefits and discipline to management) and that these benefits should be weighed up against three significant cost of debt (Agency cost, Bankruptcy and Loss of future flexibility). The rule he argues that firms should therefore use to choose its capital structure is that “if marginal benefits of borrowing exceed the marginal costs, the firm should borrow money otherwise the firm should use equity”. The debt trade-off theory proposed by Damodaran is excellent on paper, they are however all qualitative models. There is nothing to illustrate where the optimum point lays on the firm values curves, all it shows is that a trade-off exist.
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In 1976 a new brand of literature was established in relation to capital structure called the agency theory. If the M&M assumptions were removed, managers will therefore have reasons to act for themselves and may possess more information about the firm than the market. Agency theory identifies that the separation of ownership and control in companies creates tension and conflict of interest between the company's director and its shareholders. This is due to the fact that managers are most of the times in the position whereby they can use the firm resources to their own advantages thereby negatively affecting shareholders wealth maximization.
Jensen and Mecklin looked at a firm run by a single manager, who owns shares in the firm, deciding whether to issue debt or equity. If the firm issues equity, the manager's stake in the firm is diluted, reducing his concern with the value of the firm and as a result leading him to trade off firm value for his own private benefits. Therefore, the more debt issued, the greater the manager's stake in the firm and the less likely he is to take private benefits. In the case of BT, increasing managerial effort incentives may have been the motive for issuing more debt. Like most other capital structure authors, however, JM argue both for and against debt. They counter the benefit discussed by saying issuing too much debt will give the manager such a large ownership that he will want to take even the risky projects on (risk shifting). This is simply because he will stand to gain massively on the upside of the project and lose nothing on the downside since equity holders are only paid from what's left after paying the debt holders. By trading off these benefits and costs of debt, JM obtain an optimal capital structure.
Bankruptcy in firm is one of the most popular economic occurrences; it causes a lot of downfall of most companies. Two to six percent of all companies a year go bankrupt in market economy (Isachsen A. J., Hamilton C., 1992). That's why bankruptcy is defined as a macroeconomic problem (Purlys C., 2001), an inevitable appearance in market economy (Tvaronaviciene M., 2001). Managers of the company must constantly look for the ways and means to avoid bankruptcy. Only the companies that make proper analysis and where the managers seek to rule the processes that are concerned with business risk efficiently, can determine forthcoming crisis beforehand, react with expedition and reduce the risk of bankruptcy.
Having looked at the rule that firms should choose the mix of debt and equity by trading the benefits of borrowing against the cost, there are also different alternatives which firms may find useful.
Benchmarking could be good substitute. This is simply technique whereby firms would look at what similar successful companies around their industry are doing and try to incorporate the capital structure to their firm. It can be a dangerous technique if not applied correctly, or if the firm don't know what is being done. Damadoran suggested this technique can be dangerous under two situations, the first is whereby there are wide differences in the growth potential across companies within the sector and also when firms have too much or little debt. For example, if new competition breaks down monopoly power, then stable earnings could turn into volatile earnings and companies will be carrying too much debt.
Another suggest alternative would be the signalling Theory (Ross 1977, and Leland and Pyle 1977). It is based on the assumption of informational advantage possessed by managers as insiders as opposed to outside investors who would know much about the financial position and performance of a firm. Due to this reason investors may make unsure assumptions about the firm. Ross (1977) looks at the markets perceptions of a manager's ability. As debt carries a bankruptcy threat, high ability managers are thought to be able to separate themselves from low ability managers by issuing more debt to signal how good and confident he is that the firm will repay a high level of debt. The market, in theory, reacts to this signal and firm value rises.
Leland and Pyle (1977) develop a simple model of capital structure in which managers seek financing for projects whose true values are only known to them. If they issue a small amount of equity, their stake in the firm remains high and this can signal that the value of the project is also high. They therefore suggest firms avoid issuing large amounts of equity.
To conclude this essay, based on my research on capital structure, it seems that the optimal capital structure varies by industry and firm. Mostly depends on operating leverage of the firm, also on debt, interest rates, taxes and what the firms' expected profitability. Firms may prefer to raise the additional capital required through a loan rather than by issuing additional equity. It is because lenders of capital have no right of control in a firm, nor do they have any rights to participate in the profit beyond receiving the agreed interest on money lent. This interest is payable to the lender of capital whether or not the company yields profit in that year. If the firm is unable to meet the interest due on the loan, the lender has the right to put the firm into liquidation and to receive payment of both principal and interest out of the proceeds of the sale of the firm's assets.
Firms do have target rations of debt to equity. If debt weighs too heavily in their capital structure, they acquire equity by retaining earnings or issuing stock. If the debt ratio is too low, they favour debt over equity. But firms are never precisely on target. They are continually flexible by changing business conditions.