Analysis of the Risk and Value Implication for Capital Structure Issues Essay

Introduction

Leverage is an investment initiative where the business organization uses debt to finance its business operations. In most cases the borrowed money is specifically used to enhance return on an investment (Cai& Zhang, 2011). Leverage is also essential in generating finances required in buying assets such as plant and machineries usually used to generate profits. The company with more debt capital than equity is said to be highly levered thus 50 percent +1debt as compared to equity. Business organizations usually use both debt and equity capital to finance its investment portfolios. Both the use of debt or equity has some implications which makes investors to either prefer debt to equity finances.

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Implication of Leveraging Debt Finance

The use of debt finance to finance the investment project of a company has both negative and positive implications(Isaac, 2003). It allows the business or a proprietor to maintain control of the business and that is an essential thing that protects the business from interferences from outside. The only obligation that the business has is to make debt repayment upon the agreed period at the time the debt is taken and it becomes the end of the company liability. Once the debt has been taken the company has a full right to manage the business without the influence of the lender. Leveraging debt financing also provides tax advantage by having tax deductions. This is because higher levered company gets tax shield interest factor which is a nondeductible expense thus reduce tax liability the business submits to the Government (Cai& Zhang, 2011). This is an essential step that increases the return on investment at the end of financial year. A high levered company also payslower interest rates because when the Government charges a lower tax on debt, it also reduces the tax rate that the lender charges on debt capital. For example, when the financial institution charges a10% interest rates and the Government imposes a tax of 30% on the business, the business will only pay an interest rates of 7% (1-30%) rather than 10%.

The use of debt capital to finance the investment project also has some negative implications (Dang, 2010). Paying back the debt increases the business liabilities but it is only easy when there are sufficient revenues flowing into the business. When there is a low return on investment, it becomes stressful because the investors have the obligation to pay the debt from personal savings. It is more stressful when the business is forced into bankruptcy due to failure of the business, the bank will claim for payment before other shareholders. Therefore, it is a risky option to take in some point (Lee, 2016). Debt finance also requires payment of higher interests on debt. Because the lender will require payment of interest on monthly basis and the debt, leveraging debt becomes very expensive in the long run and this reduces profitability of the business.

Furthermore, debt financing also has an effect of credit rating of accompany and it can prevent the business from taking another debt from other sources of finance. It has a greater effect when the business takes a huge debt as it may translate into a higher interest rates and exposes the lender into a higher risk of failure to receive the debt back(Isaac, 2003). Finally, it reduces the amount of cash flowing into the business. The business that uses more debt than equity has an obligation of paying debt and interest at the end of every month and this increases the amount of cash that leaves the business.

Illustrations

A company BXY borrowed a long term debt of $4million at the rate of 12%. It uses the money to earn after tax rate of 14%. The interest on debt is tax deductible. When the tax rate is 40%, the after tax rate of 14% would be 12%(1-0.4) =7.2%. The difference between 6.8% (14%-7.2%) would be the earnings per share but without the impact of debt it would have been (14%-12%) = 2%

Critical Review of Capital Structure Theories

Capital structure is the proportion of debt and equity capital that the business organization uses to finance its assets. There were two professors who studied capital structure in 1950s and came up of different theories that can effectively explain the capital structure of a business. They included Modigliani and Miller and in their examination they formed capital structure irrelevance of propositions (Seferiadis, 2016). These two theorists posited that in a perfect market economy, capital structure does not matter but the company can either use a higher debt or equity so long as it has sufficient source of finance to finance its investment. They also predicted that market worth of a business organization is computed by its earning power and the riskiness of its assets but it is not associated with the kinds of finance the company uses to finance its investment portfolios. The propositions of Modigliani and Miller are based on various assumptions such as absence of taxes, transaction costs, bankruptcy and other basic things.

In every market economy, there are taxes, transaction costs, bankruptcy costs and variation in borrowings and the impact of debt on the company earnings, it is therefore not right to ignore them when designing a good capital structure. In order to appreciate the work of Modigliani and Miller after incorporating taxes, it is essential to comprehend the basics of their propositions I and II in the absence of taxes (Frydenberg, 2011). In this case weighted average cost of capital does not change with any change in the capital structure when there are no taxes, bankruptcy cost and transaction costs. It does not depend on how the company acquires its finances, there will be no tax benefits arising from interest payments and this does not affect WACC but remains constant. Because there is effect on increasing debt capital, the change in capital structure also has no effect on the price of shares of the company and this makes the capital structure irrelevant to the value of company shares. The share price is only affected by taxes and bankruptcy cost and therefore they are relevant in computing capital structure.

The tradeoff theory of leverage indicates that there are some benefits of leverage in capital structure until an optimal capital structure is developed. According to this theory there are some benefits enjoyed from interest payment.

Tradeoff theory of Capital Structure

The use of debt provides interest tax shield which is a tax deductible thus it reduces the amount of tax the company pay at the end of financial year. Furthermore, actual rates of interest that business organizations pay on debt is also lower than the nominal rate of interest as it allows tax savings (Seferiadis, 2016). There is also additional cost incurred when financing the business investment using debt. Usually the marginal gain rises when debt capital reduces but marginal cost increases in such a way that the company that optimizes its net worth must pay attention to this tradeoff when determining the amount of debt or equity to use to finance its investments.

In the contrary pecking order theory makes attempts to examine the cost of asymmetric information. In the theory there is a hypothesis that most business organization give priority to their sources of funds based on the least resistance (Seferiadis, 2016). They only use equity capital as the last option but gives internal sources of finance the first priority. The company can only use equity finance when debt capital has also been depleted.

Comparison of the Actual Debt Choices that Firms Make

Firms make debt choices that match the lifespan of their investments (Visconti, 2013). The firms that have a shorter lifespan use short term debts so that the investment can repay the debt by itself. It is irrational to take a long term debt for an investment with a short lifespan. This is because it the investment will come to an end before the debt has been repaid in full. In the contrary it is risky to take a short term debt for a firm with a long term investment plan (Isaac, 2003). This forces the company to borrow again and again to finance the investment project. It is therefore important for a firm to choose a type of debt that matches with the lifespan of the asset. Choices of debt adjust across industries depending on the lifespan of the investment projects. The choice is also made based on the riskiness of the investment projects in a given industry (Ruf, 2009). Industries that have risky projects tend to use less debt because the cost of debt tend to be high as compared to industries with less risky investment projects. They therefore avoid higher debt because they are likely to pay higher interest rates on debt.

Conclusion

Capital structure is the proportion at which a firm uses debt and equity. It is important for the company to use optimal capital structure which does not have too much debt or equity. The use of too much debt increase the cost of finance which reduces return on assets. It is also unnecessary to use excess equity capital at it prevents the company from benefiting from interest tax shield. Therefore, the application of capital structure theories is very important in establishing an optimal capital structure to use in any business organization.

References

Cai, J., & Zhang, Z. (2011). Leverage change, debt overhang, and stock prices. Journal of Corporate Finance, 17(3), 391-402. doi:10.1016/j.jcorpfin.2010.12.003

Dang, V. A. (2010). Leverage, Debt Maturity and Firm Investment: An Empirical Analysis. Journal of Business Finance & Accounting, 38(1-2), 225-258. doi:10.1111/j.1468-5957.2010.02215.x

Frydenberg, S. (2011). Capital Structure Theories and Empirical Tests: An Overview. Capital Structure and Corporate Financing Decisions, 127-149. doi:10.1002/9781118266250.ch8

Isaac, D. (2003). Debt Finance.Property Finance, 123-146. doi:10.1007/978-1-137-08239-8_7

Lee, G. (2016). Deferred compensation withdrawal decisions and their implications on inside debt.Finance Research Letters, 19, 235-240. doi:10.1016/j.frl.2016.08.007

Ruf, M. (2009). How Can Firms Choose Their Leverage? - Tax Planning for Implementing Tax Induced Debt Finance. SSRN Electronic Journal. doi:10.2139/ssrn.1336476

Seferiadis, K. (2016). Review of Capital Structure Theories: Empirical Evidence of UK Market. SSRN Electronic Journal. doi:10.2139/ssrn.2838414

Visconti, R. M. (2013). Evaluating a Project Finance SPV: Combining Operating Leverage with Debt Service, Shadow Dividends and Discounted Cash Flows. International Journal of Economics, Finance and Management Sciences, 1(1), 9. doi:10.11648/j.ijefm.20130101.12