Role of Debt in Capital Structure of Firms
Info: 5444 words (22 pages) Dissertation
Published: 6th Dec 2019
Capital structure has got importance in the literature of corporate finance. It provides insight about the role of debt in the capital structure of a firm. It is believed that firm endeavors to uphold optimal capital structure. In existing literature, however, there is no consensus among researcher’s about the level of optimal capital structure because of variation in proxies used to measure the same attribute, variation in industry norms (size, location and technology), agency cost (management ownership and competence) etc. The main objective of a firm is to maximize its profit and to give maximum return to its shareholders. For this purpose the company should use Optimal Capital Structure so as to achieve the desired targets, but usually when the time comes for the generation of capital, firms go with the more easiest way. The study investigates the relationship between the weighted average cost of capital (WACC) with Debt / Equity ratio of the firms in the Fertilizer Sector through, cross sectional analysis for the financial year 2010. The present study depicts that firms always keep in mind the tax shield. They usually prefer debt due to tax shield but some firms go with the more easiest way to raise capital, and the concept of optimal capital structure is set aside. In Pakistan, the interest rates are usually high as compared to developed countries. That is why, big firms usually prefer to raise funds through equity instead of debt. Since, financial institutions offer loans to profitable firms, at low rate keeping in view their credit rating and riskiness of operations, so these firms like fertilizer companies also include debt in their capital structure. The results are constructed with the literate review concluding that there is no consensus among researcher’s about the level of optimal capital structure because of variation in proxies used to measure the same attribute, variation in industry norms (size, location and technology), agency cost (management ownership and competence) etc. Further, maximization of stock return for different firms is debatable.
Capital structure theories provide insights about the role of debt in the capital structure of a firm. In corporate finance literature, it is believed that firm endeavor to uphold optimal capital structure. In existing literature, however, there is no consensus among researcher’s about the level of optimal capital structure because of variation in proxies used to measure the same attribute, variation in industry norms (size, location and technology), agency cost (management ownership and competence) etc. Further, maximization of stock return for different firms is debatable.
Various decisions taken by management include operating, financial and non- financial decisions. Financial structure (capital structure) decisions have gained importance in corporate finance, strategic management and financial economics literature. These decisions have implication for shareholder’s value. Capital structure comprises of debt and equity, the choice of which is associated with different levels of benefit and controls. There have always been controversies among the researchers about the optimal capital structure of the firm because of significant variation with regard to capital structure of the firm because if significant variations with regard to capital structure existing in different industries and among firm within the same industry. Further, the different proxies may be used to measure the same attribute of a variable. Selection of these proxies may create biasness. Conventional determinants of capital structure in existing literature include collateral value of asset, non-debt tax shield, growth, uniqueness, industry classification, size volatility, and profitability.
Use of debt in capital structure of a firm acts as a monitoring device over managerial actions. Use of debt puts pressure on managers to enhance the performance of a firm so that sufficient cash flows are generated to retire loan obligations.
The main objective of business firm is to maximize the wealth of shareholders in the long run, the management should only invest in projects which give are turn in excess of cost of funds invested in the projects of the business. The difficulty will arise in determination of cost of funds, if it raised from different sources and different quantum’s. The various sources of funds to the company are in the form of equity and debt.
The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. There are variations in the cost of capital due to the fact that different kinds of investment carry different levels of risk which is compensated for by different levels of return on the investment.
There are two main sources of capital for a company: shareholders and lenders usually debenture holders and financial institution’s. The cost of equity and cost of debt are the rates of return that need too be offered to these two groups of suppliers of capital in order to attract funds from them.
The cost of capital consist of four elements: Cost of Equity (Ke), Cost of Retained Earning (Kr), Cost of Preferred Capital (Kp) and Cost of Debt( Kd).The funds required for the project are raised from the equity shareholders which are of permanent nature. These funds need not be repayable during the life time of the organization. Hence it’s a permanent source of funds. The equity shareholders are the owners of the company. The main objective of the firm is to maximize the wealth of the equity shareholders. Equity share capital is the risk capital of the company. If the company’s business is doing well the ultimate beneficiaries are the equity shareholders who will get the return in the form of dividends from the company and the capital appreciation for their investment. If the company comes for liquidation due to losses, the ultimate and worst sufferers are the equity shareholders. Sometimes they may not get their investment back during the liquidation process.
The following methods are used in calculation of cost of equity. First is Dividend Yield Method. The Dividend per share is expected on the current market price per share. As per this method, the cost of capital is defined as “the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sales (or the current market price) of a share. This method is based on the assumption that market value of shares is directly related to the future dividends on the shares. Another assumption is that the future dividend per shares is expected to be constant and the company is expected to earn at least this yield to keep the shareholders content.
Second method is Dividend growth Model in which shareholders will normally expect to increase year after year and not to remain constant in perpetuity. In this method, an allowance for future growth in dividend is added to the current dividend yield. It is recognized that the current market price of a share reflect expected future dividends. The dividend growth model is also called as “Gordon dividend growth model.
Third model is Price Earning Method which takes into consideration the Earning per share(EPS) and the market price of the share. It is based on the assumption that the investors capitalize the stream of future earnings of the share and the earnings of a share need not be in the form of dividend and also it need not be disbursed to the shareholders. It based on the argument that even if the earning are not disbursed as dividends, it is kept in the retained earnings and it cause’s future growth in the earnings of capital, the earning per share is divided by the current market price.
Forth model is Capital Asset Pricing Model which divides the cost of equity into two components, the near risk-free return available on investing in government bonds and an addition risk premium for investing in a particular share or investment. This risk premium in turn comprises the average return on the overall market portfolio and the beta factor (or risk) of the particular investment. Putting this all together the CAPM assesses the cost of equity for an investment.
The empirical study done by Modigliani and Miller (1958) depicts the basis of capital structure. Under the assumption of market perfection, they argued that the value of firm is independent from its mode or source of financing. They believe that cost of capital had no influence on the capital structure, so according to them there exists no capital structure. The level of leverage may be different in the firm or within the same industry. In their point of view, the value of firm is not determined by however, the firm finances its assets but by the real assets possession is the actual value of a firm.
Researchers have relaxed the unrealistic assumptions in Modigliani and Miller proposition. In real life there exists information asymmetry. Debt payments are subject to tax shield. Agency costs reflect a tradeoff model where decrease in agency cost of equity will cause an increase in agency cost of debt Jensen and Meckling (1976) They argue that agency costs, however, reduce because use of debt restricts issuance of equity, which in turn strengthens managerial ownership. It helps to reduce agency conflicts.
Myers and Majluf (1984) argue that use of debt reduces agency problems. Further, leverage also bring its own agency cost that generates a conflict between agency cost of debt and equity.
Jensen (1986) argues that use of debt constrains the free cash flow explanations give birth to its fixed nature of obligations. Since managerial compensation had controlled the positively related firm’s to grow, therefore, investors may invest available cash flows optimally or utilizes the available cash flows to pay dividends or profits. When profits are paid at low rate due to some reason, it extremely impacts the shares market price. Use of debt generate limits to the managerial discretion to use such cash flows fully because of non-payment of profit on debt may take a firm bankruptcy. Further, firms that use debt faces extreme scanning by debt holders. These facts indulge managers to utilize their resources optimally which ultimately enriches firm value.
The theoretical framework of capital structure begins with the seminal paper of Modigliani and Miller (1958) who postulate that capital structure of a firm is irrelevant in perfect capital markets. By using net operating income approach, they argue that the overall capitalization rate remain constant for any level of financial leverage. That is, the total risk of security holders of a firm remains unaffected for any change in capital structure. Therefore, value of a firm is independent of the capital structure of a firm. Their theory is based on unrealistic assumptions of no income taxes, no transaction costs, no information asymmetry, no bankruptcy and agency cost etc. They believe in the conservation of investment value. The researchers have relaxed the assumption of perfect capital market assumed by Modigliani and Miller. Following theories explain the relevance of capital structure under different market imperfection.
Trade off theory relaxes the assumption of bankruptcy costs. It considers the cost of financial distress (bankruptcy cost, reorganization cost and non-bankruptcy cost). It elaborates the impact of financing cost and tax shield on debt. According to trade-off theory, increase in debt is positively related to marginal cost of debt and negatively related to marginal benefit of increase in debt. A firm focuses on trade-off between marginal benefit and cost of debt while deciding about the proportion of debt and equity in its capital structure with a view to optimize the overall value of the firm. A firm should borrow until the marginal tax advantage of additional debt is offset by the increase in present value of the expected costs of financial distress. This theory has been criticized by researchers on different grounds. For instance, Miller (1977) argues that firms pay large taxes frequently, whereas occurrence of bankruptcy is not recurring in nature. So, low weights are assigned to bankruptcy cost. Further, in reality, firms do not have higher weightage of debt in their capital structure.
Pecking Order theory of capital structure is based on the costs of asymmetric information. It assumes relevance of asymmetric information only for external financing. It describes the sequence (internal financing to external financing) that a firm uses to finance its capital expenditures. According to pecking order, a firm having sufficient profits and cash flows use internal funds first. It will go for external financing if internal funds are not sufficient. While deciding about external financing, a firm will issue the safest security like bonds; debenture or term-finance certificates and equity will be used as the last option. Further, in case the internally generated cash flows exceed the capital investment requirements, these excessive cash flows will be utilized to repay debt instead of buying back equity.
Milton and Artur (1991) discussed the theory of capital structure grounded on four basic factors. Firstly, agency cost that shows conflicts among managers, equity holders and debt holders. Secondly, there is asymmetric information and it explains the possible capital structure. Thirdly, it is centered on the product/input market interactions with Capital structure. Fourthly, it describes theories driven by co-operate control consideration it shows the linkage between the market for co-operate control and for Capital structure.
Peter and Gordon (2005) have discussed the importance of industry to firm-level financing and real its decisions. The findings of this paper were financial structure that depends on a firm’s position within its industry and In competitive industry, a firm’s financial control depends on its natural hedge the activities of other firms in this industry, and its status as entrant, current performance, or exiting firm. Financial control is higher and less discrete in concentrated industries, where strategic debt interactions are stronger, but a firm’s natural hedge is not significant. Our finding shows that financial structure, technology, and risk are jointly determined within industries. These findings are reliable with recent industry equilibrium models of financial structure.
The analysis made by Laurence et al (2001), discusses the Capital Structures in developing countries uses a new set of data to assess whether capital structure theory is transferable across countries with different influential structures or not. In this analysis they used 10 developing countries and provided evidence that these decisions are affected by the same factors as in developed countries. However, there are persistent differences across countries, indicating that specific country factors are at work. their findings suggests that although some of the insights from modern finance theory are transferable across countries and much remains to be done to understand the impact of different institutional features on capital structure choices.
This paper affirms the arguments on the tax shield valuation as it remains a hot issue in the financial literature. Basically, two methods have been projected to incorporate the tax benefit of debt in the present value computation: The adjusted present value (APV), and the weighted average cost of capital (WACC). This note clarifies the correlation between these two apparently different approaches by offering a formula for the WACC. Firms’ interest expenses are tax deductible. Therefore, debt increases the cash flows available to stockholders and bondholders by the amount of the tax reduction.
Joseph & Ignacio (2005), discusses the cost of debt is the market rate or unsubsidized rate for which an investor is willing to pay. In further detail debt creates and sustain its value when tax shield is applied and the rate is sustainable but if the rate of repayment is high then form the loan and at a low market rate then loan will be preferable as it is subsidized debt and no tax is applied, the firm would be a benefited with debt financing, and the unlevered and levered values of the cash flows would be unequal. And the optimal rate of return and WACC can be achieved if a firm follows the rules and take into account all sources of financing.
Tom and Timothy (2004) assumes that the use of weighted average cost of capital (WACC) is better then the use of any other calculation because either it may be riskier or will not depict the true picture of the financial performance or the position of the firm. This paper encourages the usage of WACC in all the firms although it is difficult to calculate and had some mathematical complexities but after that it depicts a clear picture of the firm, as by using spreadsheets it is easy to present the findings of the company to its managers, clients, colleagues and shareholders.
The WACC is a fundamental concept in corporate finance. Its basic definition is averaging the cost of capital coming from both the equity and the debt by Farber at el (2006) and it looks simple. But the fact is its practical implementation which has raised several questions, they are most likely the distinction between book value and the market value. This paper addresses more in depth the tax shield valuation and establishes a general formula that remains valid for any debt structure. In this context, there contribution allows not only to compare the usual WACC computation in a more rigorous way but also less synthetic one, and helps the firms to adapt the WACC approach to any chosen tax shield valuation model. In this sense, the WACC appears as a powerful and very adaptable concept.
Greg (2004), discusses what is WACC and what are there components and how these components are calculated and are helpful in the calculation of WACC. The paper further discusses that what should be the minimum discount rate that make intuitive sense to invest or to add a firm in portfolio. It also explains that what is the cost of debt, cost of financing and the components of cost of financing.
Myers and majluf (1984), argues that the use of debt reduces agency problems and further leverage also brings its own agency cost that’s generates a conflict between agency cost debt and equity.
Jenson (1986), states that the use of debt will restrict the cash flow projections due to its fixed rules. Since marginal benefits and control it’s positively related to firm development. Therefore management may invest available resources to obtain cash flows. When dividend are paid but at a low rate its adversely affect the share price in the market. The usage of debt limits the firm to invest else-where because the non-payment of the debt leads to bankruptcy.
Lakshmi (1994), differentiates between the traditional capital structure models and the new pecking order theory model of the corporate financing. The basics of pecking order theory model assumes that the debt financing driven by the internal financing, has much more time series explanatory power than a static trade of model, which predicts that each firm adjusts gradually toward an optimal debt ratio. And had shown in their results that the power to reject the pecking order against trade of theory.
The model of (CAPM) given by William and John (1964,1965), gives evidence of the birth of asset pricing theory for which noble prize was given to sharpe in 1990. Forty years later CAPM is now publically used in estimating the cost of capital of the industry and evaluating the esteem to have the maximum profits from the portfolio invested in. The attractiveness in estimation of CAPM is that it offers a wide pleasing range of predictions about how to measure and ensure the risk and the relation between expected returns and risk. Unfortunately, some problems of CAPM’s may reflect the theory may fails at some times, the result of many not be as per assumptions. But they may be caused by difficulties in implementation of valid tests to the model.
Dan at el (2005) examine the entire associations between leverage, corporate and personal taxes, and the firm’s cost of equity to generate capital. Expanding the theory of Modigliani and Miller (1958, 1963), the cost of equity capital can be expressed as an impact of leverage and corporate and level taxes. The predictions that the equity cost will increase in leverage, but that corporate taxes shifts from leverage related risk premium, while the personal tax disadvantage of burden of debt reduces the profit. They examined the findings by using implied equity cost estimation system of the firm’s corporate tax rate and the personal tax gives a big advantage of debt. Their result suggests that the premium equity risk is linked with the profit, and if the entire profit is decreasing the corporate tax generates benefit. They also marked evidence that the premium equity risk has relations with leverage, and increase in entire profit may give a results in increased in personal tax.
Rodolfo (2008) sets forth the contribution to this long lasting debate on cost of capital, firstly by introducing the multiplicative model that helps to calculate the rate of WACC. Secondly, by making adjustments in the rate of governance risk. The older approach says that the cost of capital might be calculated by means of a weighted average of debt and capital. But this is not a correct way of calculation and that might bring misappropriation, whereas the multiplicative model not only calculate the linear approximation but also the joint outcome of expected costs of debt and stock, and its proportion in the capital structure of that firm.
Nevins (1967), explains in reference to Modigliani and millers discussion that how leverage can be effective and efficient to increase the entire cost of capital of the industry or the firm. He also discusses in detail that when the account is taken of risk and is ruin an increasing cost of capital is perfectly the same with little arbitrage operations. Giving ways to the chances of bankruptcy is tantamount to relax the that entire stream of operating earnings Is independent from the entire capital structure.
Robert (1988), argues the effect of corporate and personal taxes on the firm’s optimal capital structure and financing decisions under uncertain defined conditions. It further more discussion they discussed the entire capital structure model by categorizing them entire firm’s important investments decisions. The results suggests that when investment was allowed to adjust optimally the existing assumptions about the relationship between investment and debt related tax shields must be changed. Secondly, they discussed that the increases in investment related tax shields changes due to corporate tax code are not necessarily linked with reductions in profits at the individual and company’s level. In cross sectional analysis, firms with bigger investment tax shield. Need not to have lower debt tax shields unless all the market utilize the same mechanism. Differences in production technologies in the entire market may query questions that why the empirical results cross-sectional analysis do not meet the expectations of the researchers.
Alan reviewed the financial consumption and behavior of the company to increase their profits and wealth of their existing shareholders. They mainly focuses on the impact of personal income and capital gains and taxes, and discovered that in the presence of different taxation systems of dividends and capital gains, wealth maximization does not imply maximization of firm market value and the source of equity financing is not irrelevant. The approximate cost of capital in the presence of income taxes does not depend directly on either the dividend payout rate or the tax on dividends paid. Equity shares have a market value lower than the difference between the production cost of a company’s assets and the current market value of its debt obligations. Because of this capitalization, it need not be true that an economy without taking risks and uncertainty there would have no financing.
The detail literature review enabled us to construct the following hypothesis.
H0: The firm with high debt/ equity ratio should have less cost of capital.
H1: The firm with lower debt/ equity ratio should have higher cost of capital..
This chapter describes the methodology to investigate research problems in order to draw conclusion for the present study. Research methodology comprises of research method employed identification to the problem criteria for sample selection methods for data collection and construction for measuring instruments. It comprises of the brief description of variables and proxies used to measure those variables. It also describers research limitation and ethical concerns.
3.1 Research design and data description
As stated earlier, the objective of the study is to explore the relationship between the Debt / Asset Ratio and the weighted average cost of capital. For this purpose we have targeted four companies of fertilizer sector from Pakistan into year 2010.
Basically there are four companies in the Fertilizer sector listed under the roof of Karachi Stock Exchange, but three of them are selected at random. Therefore, the sample size comprises of almost cover 75% of the fertilizer sector.
3.2 Model Description
As stated earlier the study has been under taken to investigate the relationship of Debt / Equity Ratio and weighted cost of capital in the industry. Following models are used to calculate the cost of capital.
3.2.1 Cost of debt
The capital structure of a firm normally include the debt component. The debt may be in the form of Debentures, Bonds, Term Loans from Financial Institution’s and Banks etc. The debt carries a fix rate of interest, irrespective of the profitability of the company. Because the coupon rate is fixed, the firm increases its earning through debt financing. Then after payment of fixed interest charges more surplus is available for equity shareholders, and hence EPS will increase. An important point to be remembered that dividends payable to equity shareholders and preference shareholders is an appropriation of profit, whereas the interest payable to debt is charged against profit. Therefore, any payment towards interest will reduce the profit and ultimately the company’s tax liability will decrease. The phenomenon is called as tax shield. The tax shield is viewed as a benefit that accrues to the company which is geared.
3.2.2 Price Earning Method
This method takes into consideration the Earning per share(EPS) and the market price of the share. It is based on the assumption that the investors capitalize the stream of future earnings of the share and the earnings of a share need not be in the form of dividend and also it need not be disbursed to the shareholders. It based on the argument that even if the earning are not disbursed as dividends, it is kept in the retained earnings and it cause’s future growth in the earnings of capital, the earning per share is divided by the current market price.
We have selected price earning method as this method provides us the required results. Although there are various methods to calculate the cost of Equity but there are some limitations applied on them.
3.2.3 Debt / Equity Ratio
The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholder’s’ equity and debt used to raise the company’s capital. It is also known as Risk, Gearing or Leverage Ratio. The two components are often taken from the firm’s balance sheet or statement of financial position, but the ratio may also be calculated using market values for both, if the company’s debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.
=Long Term Interests Bearing Debt/ Total Equity
3.3 Companies Included in the Study
Following companies are included in this study from the Fertilizer sector for detailed analysis.
Fauji Fertilizer Limited. (FFC)
Fauji Fertilizer Bin Qasim Limited. (FFBL)
Dawood Hercules Chemicals Limited. (DAWH)
3.4 Limitations of The Study
Although there are various methods to calculate the Cost of Equity but there are some limitations. For instance, Gordon Growth Model cannot be applied because the firms in Pakistan do not pay dividends at perpetual constant growth rate. The other technique Capital Asset Pricing Model of calculating the Cost of Equity will create biasness due to real adjustment of inflation premium in real rate of interest to calculate the risk free rate of return. Further, the return on market portfolio requires a detailed analysis of stock returns with other financial indicators. Therefore, the study uses Price Earning Method due to availability of actual and exact data.
Empirical Study Of Fertilizer Sector
This chapter includes the descriptive results and detailed analysis. The detailed analysis of Fertilizer sector is given below. It includes Cost of Debt KD, Cost of Equity KE, the WACC and Debt / Equity Ratio of the three companies which fall in the fertilizer sector.
The present study empirically investigates the relationship between the Weighted Average Cost Of Capital and Return On Assets. We have chosen three fertilizer companies listed in Karachi Stock Exchange.
Name of Company
Debt/ Equity Ratio
Fauji Fertilizer Limited
Fauji Fertilizer Bin Qasim Limited
Dawood Hercules Chemicals Limited
After the detailed analysis, the study concludes that Fauji fertilizer has low debt / equity ratio as compared to Fauji Fertilizer Bin Qasim Limited and higher WACC. Which is consistent with our hypothesis that H0: The firm with high debt/ equity ratio should have less cost of capital. In the case of Fauji Fertilizer Bin Qasim Limited it has higher Debt / Equity ratio as compared to Dawood Hercules. So accordingly, its WACC is less than Dawood Hercules which is consistent with our Hypothesis. Further, when we compared Dawood Hercules with Fauji Fertilizer the study concludes that, though the debt / equity ratio of Fauji Fertilizer has greater Debt / Equity Ratio than of Dawood Hercules, but the WACC of Fauji Fertilizer is higher than Dawood Hercules. Which is not favorable according to hypothesis. This conclusion leads to the conclusion that while deciding about the capital structure, the firms always do not keep in mind the optimal capital structure which is subject to the availability of funds.
The present study depicts that firms always keep in mind the tax shield. They usually prefer debt due to tax shield but some firms go with the more easiest way to raise capital, and the concept of optimal capital structure is set aside. In Pakistan, the interest rates are usually high as compared to developed countries. That is why, big firms usually prefer to raise funds through equity instead of debt. Since, financial institutions offer loans to profitable firms, at low rate keeping in view their credit rating and riskiness of operations, so these firms like fertilizer companies also include debt in their capital structure. The results are constructed with the literate review concluding that there is no consensus among researcher’s about the level of optimal capital structure because of variation in proxies used to measure the same attribute, variation in industry norms (size, location and technology), agency cost (management ownership and competence) etc. Further, maximization of stock return for different firms is debatable.
Cite This Work
To export a reference to this article please select a referencing stye below:
Related ServicesView all
Related ContentAll Tags
Content relating to: "Finance"
Finance is a field of study involving matters of the management, and creation, of money and investments including the dynamics of assets and liabilities, under conditions of uncertainty and risk.
Exchange Rate Risk and Impact on Foreign Trade
This paper uses real world application of exchange rate fluctuations, its causes and impact on the economy, risks associated with it and their management, in terms of Chinese economy to show the impor...
Alternative Volatility Forecasting Method Evaluation
For many financial market applications, including option pricing and investment decisions, volatility forecasting is crucial. Therefore, the research of volatility forecasting has been an active area...
DMCA / Removal Request
If you are the original writer of this dissertation and no longer wish to have your work published on the UKDiss.com website then please: