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Capital structure refers to the mix of debt and equity by an organization to finance its investments projects. It is the combination of long-term debt, preference stock and common equity (common share capital and retained earnings). Retained earnings should never be ignored as a source of finance because it has an opportunity cost which is equal to the cost of equity. Therefore it is not a free source of finance. Theoretically, an optimum capital structure exists for every firm, and it is when the firm employs the ideal mix of debt and equity to simultaneously maximize firm value and minimize the overall cost of capital. Practically however, the optimal capital structure is almost impossible to determine.
A firm needs to manage its capital structure so as to maximize shareholder wealth. This is a critical decision for any organization. All firms have liabilities, which raise risks and cause revenues to fluctuate. This risk raising effect of constant liabilities is known as leverage. Debt is the main element of leverage. Financial leverage is the change in the earnings per share induced by the use of fixed securities to finance a company. Firms tend to avoid the very high gearing levels, because of the financial distress risk. This could be induced by the requirement to pay interest regardless of the cash flow of the business. If the firm hits a rough patch in its business activities it may have trouble paying its bondholders, bankers and other creditors their entitlement. (Baker and Wurgler, 2002, p.233). In 1977, Ross argued that bigger financial leverage can be used by managers to signal an optimistic future of the firm.
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Some of the factors that influence capital structure design are: Profitability - it should be one that would maximize returns to stockholders. Use of debt magnifies the earnings per share for a given change in either sales or in earnings before interest and taxes. Thus it has a multiplier effect on wealth. Solvency - excessive use of debt threatens the solvency of the firm and may cause financial distress costs. To buffer the shareholders, then the level of debt should not be so much as to threaten the existence of the firm. Flexibility to change or modify capital structure at minimal cost if require - for example by using convertible or redeemable instruments.
Nature of the firm's assets - a firm with lots of assets can use more debt as the assets can be used as securities. Levels of interest rates - when these are low, firms usually prefer to issue debt, whereas equity is used when the stock market is bullish. Taxable capacity of the firm - firms in the high tax bracket pay high corporate taxes and they may benefit fully from the tax savings obtained with leverage because interest may be excluded from taxation.
Balance of control - the firms stockholders usually are interested in maintaining their controlling interest , thus would use more debt financing rather than equity to reduce the possibility of dilution of control. Manager's attitude towards risk - risk-averse managers fear the market discipline that may be associated with use of debt and will therefore employ low levels of leverage in financing operations. The cost of capital refers to the rate of return required by market providers of capital. It is the rate of return that the firm must earn on its investments to maintain its value and attract funds. All firms require to have information on different sources of finance so that they can determine the cost of these different alternatives when making investment and financing decisions.
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The cost of debt is usually lower than that of equity, but firms cannot operate on debt alone, because this heightens the level of the risk of bankruptcy. Cost of capital, (K) is the financial yardstick used to allocate funds. It can be used to evaluate the performance of management in raising funds optimally. It must be minimized and controlled. Specific cost of capital (Kj) is the rate of return that is required by specific providers of capital - long term debt, preference stock and retained earnings, so that we have Kp as cost of capital for preference shares and Ke as cost of capital for equity.
(Kd) is the cost of debt to the firm, and is the yield of the company's debts. It is given by the following formula: Kd = annual interest rates/market value of outstanding debt ; Ks = preference dividend/current ex-dividend share price; The cost of equity for ordinary share capital (Ke) can be determined by using the dividend yield model, which is a discounted cash flow method or using the capital asset pricing model (CAPM).
When different sources of finance are employed in the company, then weighted average cost of capital (WACC) must be determined by weighting individual costs of capital by their proportions in the firm's capital structure. WACC can be determined by dividing net operating incomes by the total market value of the firm. It can also be expressed as:
Ko = Kd (D/V) +Kp (P/V) + Ke (E/V)
Where: Ko is the weighted average cost of capital, Kd is the cost of debt, Kp is the cost of preference shares and Ke the cost of equity.
D/V, P/V, E/V are the proportions of debt, preferred stocks and equity in the capital structure. Various theories have been developed to explain capital structure. The net income approach states that the firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in capital structure, assuming that the risk perception of the investor does not change and the debt capitalization rate is less than equity capitalization rate (Kd < Ke). The implications of this is that with a constant Kd and Ke, increased use of debt, by magnifying the shareholders earnings will result in higher value of the firm because of higher value of equity.
The net operating income approach implies that the market value of the firm depends on the market risk of the firm and is independent of the financial mix. It ignores corporate taxes, and assumes the cost of debt to be constant and that the weighed average cost of capital depends on business risk. The use of less costly debt increases the risk to shareholders thus causing Ke to increase and consequently offsets the advantage of cheaper debt.
The traditional approach theory is a compromise between the net income and the net operating income approaches. It implies that cost of capital declines with increase in leverage because debt is cheaper within acceptable limits of debt, and then increases with increase in leverage.
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Modgliani and Miller developed several theories - the first one (MM 1) being identical to the net operating income approach, and in which they argued that in the absence of taxes, firm value and weighted average cost of capital are independent of capital structure changes. The second one (MM2) in which corporate taxes were included, and in which the total after tax returns available to investors would be higher if leverage was employed. The third theory (MM3) included personal taxes as well, and they argues that when personal taxes are levied at thee same rate, the tax advantage in favor of leverage remains intact, personal taxes just reduce but do not eliminate the advantage associated with leverage. The fourth theory (MM4) was a correction of the second theory which had advocated for the excessive use of leverage, whereas in practice, firms appeared to use minimal levels of leverage.
They argued that if a firm employs leverage beyond certain limits then it must encounter financial distress costs, which are severe liquidity problems that cannot be resolved without significant restructuring or bankruptcy. The firm must therefore attempt to balance equity and debt. The greater the level of leverage, the greater the debt burden and consequently the greater the possibility of distress.
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Costs associated with actual or impending bankruptcy include assets being sold under distress conditions, legal and administrative costs, reduction in quality and productivity, ignoring employee welfare and unfairly delayed payments to suppliers. Conflicts between stockholders and creditors may delay the realization of assets, leading to deterioration of inventory. Stockholders reduce their commitment to the firm and hence adverse effects on sales and operating and financing costs.
The firm must ensure that it behaves in a manner consistent with contractual obligations to various stakeholders. Costs are minimal for unlevered firms and increase with leverage. Monitoring and agency costs become excessive for highly levered firms. According to MM4, a firm must trade off benefits associated with leverage (tax advantages) against the additional costs incurred due to the excessive use of leverage (Modigliani, 2006; p.166). According to the trade-off theory associated with MM4, profitable firms with stable earnings and assets tend to have a high debt-equity ratio whereas unprofitable firms tend to have a low debt-equity ratio. Profitable firms therefore can avail a high tax shelter associated with the use of leverage fully and the use of their assets is stable, eventually reducing the financial distress costs.
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In a study conducted by Gordon Donaldson (1961), it was observed that there is a pecking order adopted by firms in corporate firms. A firm first utilizes retained earnings, because it doesn't need much effort to obtain. When financing needs exceed retained earnings, firms seek debt finance since there is little scope for it to be mispriced and it does not dilute the balance or control. External equity is the last because of the business, legal and administrative efforts it requires. It gives a negative signal to the capital markets because it is believed that it is issued where shares are overpriced (Pataki, 2003; p.100).
According to this theory, profitable firms generally use little debt because they have adequate retained earnings. Less profitable firms therefore borrow more because their financing needs exceed what they have retained. Firm owners must always thoroughly consider the benefits and risks associated with debt before designing their capital structure. Employing debt allows the owner to control a greater volume of assets than they could have had they invested their own money only, but financial risk occurs due to the higher proportion of financial obligations in the firm's capital structure (Harris, 2007; p. 321)
Agency theory and the role of effective financial management in addressing agency problems. An agency relationship is a contract in which one or more people hire another person to perform some services on their behalf. The former is known as the principal while the latter is the agent, to whom some decision making authority is delegated (Fama, 2003; p. 340). Within the framework of financial management, this relationship exists between stockholders and managers and debt holders and stockholders. These relationships are not always harmonious and are frequently dogged by conflicts, due especially to conflicting interests in the business. There are also costs (agency costs) involved which refer to expenses incurred in order to maintain the relationship effectively.
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Agency relationship between stockholders and managers
Most limited liability companies are owned by stockholders who often appoint a Board of Directors to oversee the running of the company. This usually is because, some of the stockholders do not have time, do not have the required expertise and they may also be many and therefore cannot manage the company effectively all at the same time (Johnson, 2005; p. 155). Managers are therefore appointed and have authority to administer the company's interest. In most of these companies, the managers own a very small percentage of the stock, thus aggravating the significance of agency conflicts.
Managers may not work hard to maximize stockholders wealth if they perceive that they will not directly benefit from doing so. Since they own a significantly small percentage of stock, they may consider the goal of maximizing shareholders wealth subordinate, and instead increase their efforts towards other objectives that they consider more important for example increasing the size of the firm; through which they will increase their status, create more opportunities for lower and middle level managers and enhance their job security (Shankman, 2010).
Managers may award themselves huge salaries and other benefits more than what the stakeholders consider as reasonable. Propelling their self-interests compels them to maximize their own utility at the expense of stockholders, by allocating to themselves more corporate resources like vehicles, money, servants etc. They may also maximize their leisure time rather than working hard for the company (Myers, 2004; p.205). This is especially possible where a business owner who previously operated as a sole proprietor, managing a company himself, decides to sell off part of the stock and continues to manage the business himself. Where he previously measured utility by personal wealth, he may after the entrance of other parties, work less vigorously because of the perceived reduction in personal wealth as a result of having to split the profits with other people.
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Managers may also undertake projects with levels of risk that stockholders may not consider proper. Since they are in a better position to receive industry-specific information, some managers may avoid optimal risk projects, especially if they are risk-averse (pessimistic). They will therefore let profitable projects just slip away because they fear taking risks (Grossman, 2009; p. 36). The opposite could also occur, where risk takers, who are overly optimistic managers, may take on projects without properly evaluating their level of risk, may end up causing the company to lose a lot of money, losses which will be borne by the stockholders. They may also undertake projects that improve their self image at the expense of profitability.
The management could also buy out stock not held by them and thereby convert the company into a private one. In order to manage agency conflict, incentives, constraints and punishments may be used. Using these tools leads to the incurrence of agency costs by the stockholders. Effective financial management is required in order to address the problems associated with stockholder-manager relationships (Himmelberg, 2009; p. 361).
Various costs may be involved, inform of, for example (i) monitoring expenses like audit fees, (ii) expenditures to structure the organization so that undesirable managerial behavior is limited, such as appointing outside members to the Board of Directors or restructuring the company's business units and management hierarchy and (iii) opportunity costs associated with the loss of profitable opportunities (cost of delayed decision, arising from stockholder imposed restrictions). Agency costs may be excessive if every action by managers is checked. Conversely, if stockholders do not put their effort to contain managerial behavior, some shareholder wealth will be lost (Hayne, 2008). Thus a cost-benefit analysis should be done to determine and ensure that for every dollar spent, there is at least a dollar gained in stockholder wealth (Bamberg, 2007; p.76).
Another way to contain this conflict is to offer management profit-based remuneration including, (i) offering shares to them, (ii) giving managers share options to buy stock at a fixed price at a fixed future date, and (iii) profit-based salaries. Compensating managers based of stock price movements may also be used, although this is would expose managers to economic impacts not under their control. Other actions that could be taken include: threat of firing and threat of forceful takeover in a case where stockholder wealth falls.
Agency relationship between stockholders and debt holders
A second agency problem exists because of the potential conflicts between stockholders and debt holders (creditors). Firms borrow money, which is advanced to them by creditors based on the riskiness of the firm's assets and on the firm's capital structure and expectations of this structure to change in future. Stockholders through the firm's management may make decisions that may cause the firm's risk to change, thereby affecting the value of debt (Jensen, 2006; p. 345). If the firm increases the level of debt so as to boost profits, the value of old debt reduces and it increases the risk of the firm. If a risky project is successful, creditors do not benefit because the return on the debt is fixed at a low original debt. However, if losses are incurred, creditors are forced to incur the losses as well.
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When a company is in distress, stockholders may be unwilling to venture into projects that may be beneficial, because this action will benefit debt holders more than stockholders by providing additional security for their debt (Green, 2010; p. 611). Without increasing the assets, stockholders may through managers increase the ratio of debt to equity in order to leverage on returns on equity. This exposes the existing creditors to a higher risk as there are more parties laying claim to the firm's assets, and has the effect of transferring wealth from the firm's debt holders to the stock holders.
If the value of the firm's outstanding debt falls by more than the increase in the value of the firm's common stock (equity), the firm's total value reduces and yet stock price rises. If this becomes a trend, creditors become very cautious, and they may insist on restrictive covenants to be included in the debt contract. This may restrict the company's asset base, the company's ability to acquire additional debt, ability to pay dividends in the future and managers' ability to make decisions in future (Bowie, 1999; p.256)).
When creditors believe that stock holders are taking advantage of them, they will either refuse to extend debt or may impose higher rates of interest to buffer against the risks that stockholders may be taking. If the firm's other stakeholders including even employees perceive an attempt on the part of managers to usurp wealth, they impose constraints and sanctions. These actions are quite detrimental to stockholders in the long run. All in all sound financial management is key in ensuring that the relationship between creditors and stockholders is well maintained. This is because; the latter's wealth all depends on continued access to capital markets, which requires fair play from stockholders as far as the creditor's interests are concerned.