Week 3 Important Flashcards
Briefly explain how a company determines its target or optimal capital structure.
The target (or optimal) capital structure refers to the optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investment opportunities. The target (or optimal) capital structure for a company is determined by the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its ordinary shareholders.
Business risk
Business risk is the risk or uncertainty associated with a company’s business operations, ignoring any fixed financing effects. Specifically, business risk refers to the relative variability of a company’s operating income that arise from changes to its cost structure and/or changes to its operating environment (e.g. industry competition). Since changes in operating income affect a company’s profitability and/or financial viability, both preference shareholders and ordinary shareholders are affected by business risk.
Financial risk
Financial risk is the additional risk or uncertainty, over and above the business risk, that is borne by a company’s ordinary shareholders which arises from the manner in which the company’s assets are financed. Specifically, financial risk refers to the additional variability in earnings available to ordinary shareholders that arise from the company’s financing decisions and includes the additional risk of bankruptcy from the use of financial leverage. Since changes in the earnings available to ordinary shareholders affect a company’s ability to make dividend payments to ordinary shareholders, only ordinary shareholders are affected by financial risk.
(3) general theories of capital structures that are used to explain corporate decisions relating to the capital structure of a business.
Trade-off Theory
Signalling Theory
Pecking Order Theory
Trade-off Theory
Trade-off Theory argues that there is a ‘trade-off’ between the tax benefit versus the bankruptcy-related cost associated with debt financing. Specifically, Trade-off Theory argues that, since interest payments are a tax-deductible expense, the government effectively subsidizes part of the cost of debt capital, resulting in more operating income flowing through to shareholders. However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates. Therefore, from the Trade-off Theory’s perspective, the optimal capital structure for a company is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost, thus resulting in the minimum overall cost of capital for the company.
Signalling Theory
On the other hand, Signalling Theory argues that, owing to asymmetric information between company managers and external investors, the company management’s choice between debt financing versus equity financing is viewed by market investors as a signal about the company management’s perception of the future financial prospects for the company. Since external investors expect that companies with bright financial prospects will prefer debt financing over equity financing, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright. Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor. Accordingly, the implication of Signalling Theory is that companies should always maintain a reserve borrowing capacity by using less debt than the ‘optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.
Pecking Order Theory
Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.
The relative advantages of debt financing compared to equity financing are as follows:
Maintaining ownership and control
Tax deductions
Lower interest rates
Maintaining ownership and control
Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, by using debt financing, the owner is able to maintain ownership and control over the business.
Tax deductions
Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible, with the government effectively subsidising part of the cost of debt capital.
Lower interest rates
Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.
The relative disadvantages of debt financing compared to equity financing are as follows:
Repayment obligations
Risk of bankruptcy
Need for collateral
Repayment obligations
With debt financing, there is a need to make periodic fixed repayments to the debtholder on a regular basis. As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt. There is, however, no such repayment obligation with equity financing.
Risk of bankruptcy
Debt financing increases the risk of bankruptcy for the business. Furthermore, in the event the business becomes bankrupt, the debtholder has priority in claiming the assets of the business before ordinary shareholders. There is, however, no such risk of bankruptcy with equity financing.
Need for collateral
With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debtholder against possible default. There is, however, no such requirement for collateral with equity financing.
