In Topic 1, you learned about three important decisions that a finance manager makes. The first decision is the investment decision. The second is the financing decision or capital structure decision. Capital Structure is the mix of sources of funds used by a company to finance its activities (i.e. to finance its investment in real assets).

In this topic you will learn the following concepts:

Concept 1: Generalise major sources and types of external financing for a business

Concept 2: Characteristics of debt and equity

Concept 3: Define and measure capital structure

Concept 4: Understand theories of capital structure

Concept 5: Firm life cycle and capital structure

Concept 1: Generalise major sources and types of external financing for a business

The two major sources of external financing for a business are: Debt and Equity. Let’s understand what are debt and equity financing.

Concept 2: Characteristics of debt and equity

What is Equity financing?

Generally, when you say that a company has used equity to raise funds this means that it has issued ordinary shares (common stock) in an initial public offering (IPO) in the capital market – investors purchase the newly-issued shares in the IPO and the company issuing the shares receives the capital (finance), which is the total sale price of the shares.

What are the Characteristics of Equity?

Residual claim – Dividend payment is discretionary, i.e. ordinary shareholders receive a dividend only after a company has met its financial obligations to all other claimants, such as suppliers, employees (wages & salaries), lenders (debt & interest payments), and governments (taxation).

Also, if a company is liquidated, ordinary shareholders have a residual claim on the proceeds from the sale of the company’s assets.

Ordinary shareholders face greater risk than other investors in a company, so ordinary shareholders will expect a return greater than if they had lent money to the company.

Not Tax-deductible – The dividend payments that a company makes periodically to shareholders are not tax-deductible, so the company receives no tax benefit from using equity finance.

Maturity – infinite – as long as the company continues operating and is listed on the stock exchange then the ordinary shares will not mature, meaning that they cannot be ‘cashed-in’ with the company

Shareholders are entitled to a proportional share of any dividend that is declared by a company’s directors.

Management Control – Ordinary shareholders exert a degree of control over management of the company through the voting rights attached to their shares, e.g. the right to elect members to the board of directors, giving them some control over the company’s operations; one vote for each share held.

Shareholders have the right to sell their shares on the stock exchange (secondary market).

Advantages of Equity Finance (from the firm’s point of view)

• The Company is not required to pay dividends to ordinary shareholders – payment is at the discretion of directors.
• Ordinary shares have no maturity date – issuing company is under no obligation to redeem them.
• The higher the proportion of equity in a firm’s capital structure, the lower the risk lenders will suffer loss, thus lowering the interest rate that the company must pay on debt finance.

Disadvantages of Equity Finance (from the firm’s point of view)

• If new shares are issued, existing shareholders either have to purchase some of the new shares or suffer a dilution of their ownership and control of the company (this is especially so for those that own a large percentage of the shares in a company, e.g. institutional investors).
• Transactions costs of issuing shares is higher than the cost of borrowing a similar amount, e.g. costs of preparing a prospectus, fees paid to underwriters.
• Not Tax-deductible – cost of equity finance (dividends) is not tax deductible

Sources of Equity Financing

There are 2 sources of Equity Finance:

• Floating a public company (IPO)
• Private Equity

Floating a Public Company (IPO)

IPO – when a company first invites the public to subscribe for shares in the company – ‘floating’ the company or ‘going public’ in order to raise (equity) capital (see ASX for upcoming float and listings).

Advantages of an IPO/Listing On The Stock Exchange

1. Access to capital for growth – greater access to the capital market and, hence, to finance, which is particularly important to high-growth companies that require funds to implement attractive new projects; listing gives a company the opportunity to raise capital at the IPO stage and, throughout their listing through seasoned offerings on the secondary market to fund future growth.
2. Large capital raisings – the amount of equity capital raised through an IPO is large; ASX rule of listing – company must have at least 300 shareholders, each subscribing for shares with a value of at least $2,000 (minimum of $600,000 raised).
3. Cash-in on success – a float allows the owner/entrepreneur of a company to cash in on the success of the business that they have developed.
4. Currency for external growth – facilitates acquisitions by providing ‘currency’ in the form of a more diversified and liquid share capital base.
5. Higher public and investor profile – heightens company profile with the media, analysts and the industry at large, helping sustain demand for the company’s shares.
6. Institutional investment – attracts institutional investment due to increased transparency and trading liquidity, thereby increasing credibility and access to capital.
7. Improved valuation – helps generate independent valuation by the market based on available information.
8. Greater efficiency – leads to greater operating efficiency of the business due to ongoing reporting requirements and more rigorous disclosure.
9. Secondary market for company’s shares – stimulates liquidity in the company’s shares enabling shareholders to realise the value of their holdings and by facilitating further capital raising.
10. Alignment of employee/management commitment – provides company with the option of remunerating its employees with shares, thereby aligning employee interests with organisational goals.
11. Reassurance for customers & suppliers – improves perception of the business’s strength due to the rigorous due diligence of the listing process and ongoing compliance procedures.
12. Management – attracts top management talent and motivates current managers if a company’s shares are publicly traded.

Considerations For Listing (Possible Disadvantages of Listing)

1. Susceptibility to market conditions – a company’s share price can be affected by conditions beyond its control including general economic conditions or other events within the same industry.
2. Under-pricing – shares sold in an IPO are usually under-priced. Money is ‘left on the table and, on average, there is an immediate abnormal return to IPOs. Under-pricing is a real cost to existing shareholders – they are selling assets to the new shareholders for less than their fair value. Under-pricing – defined as the return on the first day’s trading is the difference between first day market closing price and issue price; Ritter & Welch (2002) 18.80% (US); Lee, Taylor & Walter (1996) 11.90% (Aust.); Dimovski & Brooks (2003) 25.6% (Aust.); Google 18.05%; Russia 4.2%; UK 16.0%; Japan 40.2%; Malaysia 62.6%; India 88.5%; China 137.4% (Pierson et al. Business Finance, 12^th Edition, p. 248)
3. Disclosure & reporting requirements/Directors responsibilities – requires a higher degree of disclosure and corporate governance and managing investor relations, which means additional management time, responsibility, and investment.
4. Short-Term Focus – going public may encourage managers to focus only on short-term profits (usually quarterly), rather than on long-term wealth maximisation.
5. Media exposure – heightened media exposure is a plus, at the same time, it requires management.
6. Costs & fees – additional costs are involved in an IPO, maintaining a listing and raising additional capital, e.g. ASX listing fees, prospectus costs (legal, accounting, expert opinions and printing and distribution); underwriters’ fees and brokers’ commissions (generally 4–7% of funds raised); e.g. ASX fees: 10 million shares – initial listing fee $70,000, annual listing fee $25,000.
7. Reduced level of control – the sale of company shares inevitably involves ceding a degree of control to outside shareholders.

Private Equity (PE). What is Private Equity?

Securities issued to investors that are not publicly traded, including family members & friends, & more usually the source is a private equity fund that invests equity capital in businesses. There are two Types of Private Equity:

1. ‘Venture Capital’ (VC) – funding for smaller & riskier companies with potential for strong growth. PE can be better than an IPO as capital required may be too small to justify an IPO and future of venture may be too uncertain to attract a large number of investors.
2. Acquisition of a mature listed public company by a group of investors who purchase 100% of the business and ‘privatise’ it so that it is de-listed from the stock exchange.

Four sub-types of PE

1. Start-up financing – for businesses less than 30 months old where funds are required to develop the company’s products.
2. Expansion financing – where additional funds are required to manufacture & sell products commercially.
3. Turnaround financing – for a company in financial difficulty. &
4. Management buyout (MBO) – financing where a business is purchased by its management team with the assistance of a private equity fund.

Private equity is not publicly traded, so the market for PE is generally illiquid, hence, PE investors must be prepared to commit funds for the longer-term, usually from 5 to 10 years.

Fund managers usually invest from $500,000 to $20 million for periods of 5 to 10 years.

Looking for businesses with good prospects for growth, managed by people who are capable, honest, and committed to the success of the business.

Aim to increase the value of a company, and once it is increased they sell the company for a profit.

PE investment in Australia has grown rapidly since the 1990s.

Characteristics of Debt

What is Debt finance? Debt involves a contract whereby the borrower promises to pay future cash-flows to the lender.

Legal claim & high priority in financial trouble – The borrower promises to pay future cash-flows to the lender in the form of interest payments and repayment of amount borrowed; if not, lender can take possession of pledged assets (on a secured loan), and/or take legal action against borrower to recoup their (i.e. borrower’s) money.

Tax-deductible – By law companies that borrow money and pay interest expense are allowed to claim the interest expense as a tax-deductible expense, i.e. the interest paid each year can be included as an expense in the company’s P & L statement, thereby providing a tax shield (reducing the amount of tax to be paid). For example – corporate tax rate is 30% and Company X has $1,000,000.00 in interest expanse, leading to a tax shield of: 0.30 x $1,000,000.00 = $300,000.00 (i.e. the company’s tax bill will be reduced by $300k).

Maturity is Fixed – Generally, there will be a maturity date with the borrowings, meaning that on a certain date the full amount borrowed must be repaid, e.g. 10-year $10,000 bond issued on 01/04/2017 – maturity date and date at which full amount borrowed ($10,000) must be repaid is 01/04/2027

No Management Control – An important feature of debt is that provided the company meets its obligations related to the debt, lenders have no direct control over the company’s operations (apart from any covenants in the debt contract). However, if company defaults on its debt repayments lenders can exert significant influence over the company, e.g. taking control of pledged assets, appointing an administrator and having the company placed into receivership, liquidating company. Thus, while lenders have no direct control over a company, they have a large degree of potential control.

Sources of Debt

Short-Term Debt has maturity/repayment within 12 months. Sources of short term debt are banks, finance companies, investment banks, & credit unions.

Types of Short-Term Debt are:

• Non-Marketable Short-Term Debt Securities (not tradeable and no secondary market for these securities), e.g. Bank overdraft.
• Marketable Short-Term Debt Securities (tradeable, with secondary market for these securities):
• Commercial paper:
  • also known as a promissory note
  • unsecured
  • promise to pay a stated amount of money (face value) on a specified future date to the purchaser (discounter)
  • discounter may on-sell the security in the secondary market; 30 to 180 days maturity
  • borrower is the only promisor, so also called ‘one-name paper’
  • only issued by blue-chip companies and governments
  • sold at a discount to the face value;

[latex]P=\frac{F}{1+rx\frac{d}{365}}[/latex]

where: P = current market price; F = face value; r = yield (simple interest basis); d = no. of days to maturity.

Long-Term Debt has maturity/repayment greater than 12 months.

Types of Long-Term Debt are:

• Loans from banks and other financial intermediaries, e.g. asset-backed loans, such as mortgages secured by property or other assets.
• Marketable debt securities, e.g. debentures, unsecured notes, and corporate bonds.

Concept 3: Define and measure capital structure

Capital structure is the mix of debt and equity finance used by a company. Optimal capital structure is the capital structure that maximises the value of a company.

Theoretically, capital structure can affect the firm’s value. By changing the firm’s debt/equity ratio, you may be able to increase/maximise the firm’s market value.

Value of Firm (V) = Value of Debt (D) + Value of Equity (E).

How do we measure capital structure?

There are two ways to measure financial leverage (or gearing); higher debt indicates a higher degree of financial leverage or gearing.

1. Debt/equity ratio – D/E;
2. Debt/capital ratio – D/V.

Capital = (equity (E) + debt (D)) = Firm value (V)

Also, the interest coverage ratio  determines how easily a company can pay interest expenses on outstanding debt; lower the ratio, more company is burdened by debt expense; ratio of 1.5 or lower indicates ability of company to meet interest expenses may be questionable.

6.1

Interest coverage ratio

[latex]Interest\ coverage\ ratio\ =\ \frac{EBIT}{interest\ expense}[/latex]

Debt and risk

Generally, there are two types of risk faced by a business:

1. Business Risk – A risk faced by all businesses; shareholders only if company is financed 100% by equity; risk posed by:

• • Changes in technology
  • Taste
  • Market competition – Coles & Woolworths v. Aldi
  • Govt. regulation

2. Financial Risk – an additional source of risk; risk involved in using debt as a source of finance:

• • expected rate of return on equity increases
  • variability of returns to shareholders increases
  • increasing leverage involves a trade-off between risk and return.

Concept 4: Understand Theories of capital structure

Modigliani and Miller (MM) analysis

Assumptions in M&M’s Perfect Markets Model:

Capital markets are perfect, i.e.:

1. Companies and individuals can borrow at the same interest rate.
2. There are no taxes.
3. There are no costs associated with the liquidation of a company.
4. Companies have fixed investment policies, meaning that investment decisions are not affected by financing decisions.

MM’s Proposition 1 – market value of a firm is independent of its capital structure.

If a company has a given set of assets, changing the debt/equity ratio will change the way net operating income is divided between lenders and shareholders but will not change the value of the company.

Two companies that have the same assets but different capital structures are perfect substitutes and should have the same value.

There is no reason for investors to pay a premium for shares of levered companies because investors can borrow to create home-made leverage.

Home-made leverage is a perfect substitute for corporate leverage.

The central mechanism in MM’s proof is the substitutability between corporate debt and personal debt.

MM’s Proposition 2

The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage of the levered firm.

For a levered firm, the WACC (overall required rate of return of the firm) is:

6.10

WACC of a levered firm

[latex]WACC_L\ =\ R_D(D/V)\ +\ R_E(E/V)[/latex] RD =Cost of Debt    RE=Cost of equity of a levered firm

Solving for R_E (the required rate of return on equity in a levered firm) is:

6.11

Return on equity for a levered firm

[latex]R_E=R_U\ +\ (R_U\ – RD) ×D/E[/latex] Note: RU is cost of equity of an unlevered firm

where R_U is the cost of equity for an unlevered firm.

This shows that as the degree of leverage increases, the required rate of return on equity in a levered firm increases exactly in line with the increase in the available rate of return.

For the capital structure to be irrelevant, the return equity holders in a levered firm require on their investment must increase in line with the return available to them.

As ‘cheaper’ debt is substituted for more expensive equity in the capital structure the return required by the equity holders in a levered firm increases in response to the increased risk associated with their investment and thereby (exactly) offsets the effect on the overall cost of capital of the ‘cheaper’ debt finance.

Why is MM’s analysis important?

MM shows what does not matter. This can also show, by implication, what does matter. In perfect capital markets, MM show that a firm’s D/E ratio does not effect its WACC or market value.

By implication, if capital structure does in fact matter in the real world (so, no longer assuming perfect capital markets), then taxes and default risk could be good places to look for reasons why it matters.

Relax the assumption of perfect capital market in MM analysis

Capital market imperfections will impede MM’s propositions. These imperfections include:

1. company income taxes
2. financial distress
3. agency costs
   • Lenders and shareholders
   • Managers and shareholders
4. information asymmetry

Capital Structure & Company Tax

Leverage will increase a firm’s value because interest on debt is a tax-deductible expense resulting in an increase in the after-tax net cash flows to investors. The main implication of Proposition 1 with company tax is clear, but it is also extreme. A company should borrow so much that its tax bill is reduced to zero.

Capital Structure and Financial Distress

Financial distress is a situation where a company’s financial obligations cannot be met or met only with difficulty. There are indirect and direct costs for financial distress.

Indirect costs of financial distress.

This involves attempting to avoid bankruptcy:

• Financial distress leads a range of stakeholders behaving in ways that can disrupt a company’s operations and reduce its value.
• Effect of lost sales and reduced operating efficiency.
• Cost of managerial time devoted to attempts to avert failure (less attention paid to issues such as product quality and employee safety).

Direct costs of financial distress (bankruptcy):

This includes fees for accountancy, legal work and liquidator. Incorporating the benefits and costs of debt leads to the following expression of the value of a levered firm:

[latex]V_L=V_U+\left(PV\ of\ Debt\right)-(PV\ of\ expected\ bankruptcy\ costs)[/latex]

where V_L = value of levered firm; V_U = value of unlevered firm.

The trade-off theory/ Static Theory of Capital Structure

Since financial distress brings significant costs for firms, managers choose a capital structure based on the trade-off between the benefits and the costs of debt. Managers increase debt to the point at which the costs and benefits of adding an additional dollar of debt are exactly equal. This point is referred to as the optimal capital structure point as it maximises company value.

Capital Structure and Agency Cost

Agency Cost: shareholders and debtholders

Agency costs arise from the potential for conflicts of interest between the parties forming the contractual relationships of the firm. Management may make decisions that transfer wealth from lenders to shareholders. The sources of potential conflict:

Claim dilution: A company may issue new debt that ranks higher than existing debt.

Dividend payout: A company may significantly increase its dividend payout. This decreases the company’s assets and increases the riskiness of its debt.

Asset substitution: A company’s incentive to undertake risky investments increases because of the use of debt. If risky investments prove successful, most of the benefits will flow to shareholders, but if it fails, most of the costs will be borne by lenders. Undertaking such investments (negative NPV) causes the total value of the company to decrease, but the value of the shares will increase and the value of the debt will fall.

Underinvestment: A company may reject proposed low-risk investments that have a positive net present value. If a company’s debt is very risky it may not be in the interests of shareholders to contribute additional capital to finance new investments.

Agency Cost: shareholders and managers

Jensen’s free cash flow theory : Suppose a company is generating high net operating cash flows because it is a profitable business. However, the company is declining because it does not have very many investment projects. Jensen (1986) argues that in these instances free cash flows should be paid out to investors in order to avoid poor use of funds by managers.

Capital structure with information asymmetry

The pecking order theory: It recognises that different types of capital have different costs. Managers choose the ‘least expensive’ capital first then move to increasingly costly capital, as follows:

1. Internally generated funds (e.g., retained earnings)
2. Debt
3. Equity

Myers explains this pecking order based on information asymmetry – a situation where all relevant information is not known by all interested parties; managers typically have more information and if they believe that shares are under (over) valued they will issue debt (shares).

Evidence of Pecking Order Theory

In the US, most investment by non-financial companies is financed from internal cash flows, followed by external debt finance, and then by equity. The pattern in Australia is similar. However, high-growth companies have investment needs that exceed cash flows and, as a result, they depend heavily on share issues (equity finance).

Concept 5: Firm life cycle and capital structure

A firm’s life cycle refers to the different stages a company goes through as it grows and matures over time.

The relationship between a firm life cycle and capital structure is that a firm’s capital structure tends to change as the firm progresses through its life cycle. In general, young firms just starting out are more likely to rely heavily on equity financings, such as venture capital or angel investors, since they may not have established a track record or assets that can be used as loan collateral.

As a firm matures and becomes more established, it may shift towards a more balanced mix of debt and equity financing, with a greater emphasis on debt financing. This is because established firms often have a more stable revenue stream, assets that can be used as collateral, and a history of financial performance that can be used to demonstrate creditworthiness to lenders.

As the firm reaches the later stages of its life cycle, such as the decline phase, it may rely more heavily on debt financing to maintain operations and fund investments since equity financing may be more difficult to obtain at this stage.

To summarise, the capital structure of a firm can be influenced by its life cycle stage, with young firms more likely to rely on equity financing and established firms more likely to use a mix of debt and equity financing.

References

• Peirson, G., Brown, R., Easton, S. A., Howard, P., & Pinder, S. (2015). Business finance (Twelfth edition). McGraw-Hill Education.
• Ross, S. A., Trayler, R., Hambusch, G., Koh, C., Glover, K., Westerfield, R., & Jordan, B. (2021). Fundamentals of corporate finance (Eighth edition.). McGraw-Hill Education (Australia) Pty Limited.
• Parrino, R., Au Yong, H. H., Dempsey, M. J., Ekanayake, S., Kidwell, D. S., Kofoed, J., Morkel-Kingsbury, N., & Murray, J. (2014). Fundamentals of corporate finance (Second edition.). John Wiley and Sons Australia, Ltd.