Business primarily raise funds using two sources of finance - debt and equity. It is imperative for the management of businesses to find an optimal mix between the proportion of debt and equity in the capital structure of a business in order to maximise returns for the shareholders of a company while minimising costs.
The objective of this chapter is to understand the key components of the capital structure of a business. The chapter will start by assessing various theories of capital structure and identifying the key factors that influences choice of the capital structure. Thereafter, the subsequent section will focus on explaining the key components of the cost of capital and its role in valuing a business. The section four will identify different sources of finance available to a business and critically evaluate the merits and demerits of each. The section five of the report will explain various theories of dividend and the role of dividend in valuing a business. Lastly, the chapter will conclude by assessing the motivations, advantages and challenges associated with mergers and acquisitions.
The capital structure of a company is the mix between various sources of capital used by the business. Capital is required for investment in fixed assets and working capital. The two main categories of capital used in a business are debt and equity, which differ in terms of their seniority and risk, and cost of capital and rewards.
According to the irrelevance theory of Modigliani and Miller (1963), in prefect markets, capital structure of a company is not relevant in determining company’s value. This argument assumes that market value is a function of the earning power and risk of assets of a firm. It is important to note that the capital structure irrelevance argument is based on perfect market condition, that is, there are no taxes and transaction costs, and investors and companies can borrow at same cost. In reality, capital markets are not perfect due to different tax rates and different costs of borrowing for companies and investors, indicating that the capital structure is not irrelevant.
A number of theories have been formulated to explain capital structures observed in practice.
The trade-off theory implies that the decision to use various sources of capital is a trade-off between the benefits and costs of different sources of capital, especially those of debt (Myers, 1984). The main benefit of debt is its lower cost. The net cost of debt is lower than the cost of equity because of the seniority of the former and tax deductibility of interest payments (McLaney, 2006), thereby implying that a firm should use debt only in financing its growth and for working capital. The lower net cost of debt implies that a firm can increase its value by using higher proportion of debt in its capital structure, since the value of a business is the sum of its discounted cash flows.
However, the cost of debt does not stay the same at all levels of financial gearing because as the level of debt increases in the capital structure of a business after an optimal point, the equity holders demand a premium for bearing excessive financial risks. The level of optimality depends on a number of factors, such as the nature of the industry and average capital structure of the industry among many other factors. Higher financial gearing increases the risk for a business because of the increase in interest payments. A business may face bankruptcy if it is unable to generate sufficient profits to meet its loan covenants, which lenders typically place on businesses to safeguard their principal. The cost of debt also increases as the proportion of debt increases in the capital structure beyond the optimal level because the debt holders of a company demand a risk premium for bearing financial risk in a company, as a highly indebted business poses a heightened risk of default to the lenders (Berk and DeMarzo, 2014). The trade-off theory suggests that a firm will therefore chose a capital structure which will minimise its weighted cost of capital, weighted according to the proportion of different sources of capital, and therefore maximise the value of a business. Such a capital structure which minimises the cost of capital is called an optimal capital structure. Other things being equal, especially no change in cost of debt, tax deductibility on higher interest payments would increase the value of the firm. The increase in gearing causes an increase in valuation up to the optimal capital structure level where benefits from the tax-deductibility of interest payments are equal to the costs associated with higher gearing.
The trade-off theory implies that firms should have the optimal capital structure to maximise their valuation. However, in practice firms do not always aim for the optimal capital structure because of a number of reasons (Graham and Harvey, 2001). A firm may not increase debt to the optimal gearing level as it wants to retain a higher credit rating to lower borrowing costs. Also, a firm may keep its financial gearing low in order to preserve its flexibility to raise additional debt in the future without substantially lowering their credit rating.
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The second theory to explain capital structure of a firm is the pecking order theory which suggests that a firm prefers internal capital than external finance for financing its business. This theory suggests that the capital structure decisions of firms are based on the availability of their internal financing and the relative costs of different sources of external capital (Myers and Majluf, 1984). The preference to internal capital is because of the asymmetric information between managers and providers of external capital since providers of external capital are expected to have less information about the future prospects of a firm, and thus they will discount the value of a firm. The pecking order theory suggests that a firm would like to retain internally generated capital to finance its business, and rely less on debt because retained earnings are least subject to the problem of information asymmetry (Jensen and Meckling, 1976).
The preference of internally generated capital is also due to the signalling effect of raising external finance. External investors will assume that a business is more likely to raise equity if its management believes that it is over-valued since the latter would not issue equity when market is undervaluing the firm as doing so would cause transfer of wealth from existing to new shareholders. This assumption of external investors means that they would expect a discount on the new capital being raised by the firm and thus, force a management to prefer internal capital over external capital for financing the business. The preference for internally generated capital over external capital makes sense if investors face higher tax on dividends than on capital gains. In such an environment, when there is no distinction between tax rates on dividends and capital gain due to retained earnings, financial managers would prefer to invest the excess earnings in assets than distributing it to the investors because they would not like to raise external capital at discounted valuation (ICAEW, 2012).
The capital structure is also influenced by specifics of a firm, such as its life-cycle stage (Bender and Ward, 2008).Berggren (2009) stated that small and initial-stage firms rely more on owners’ own funds and those obtained from friends and family. Small and new businesses find it difficult to raise debt because of the lack of performance history. This means that small and new businesses are more likely to follow the pecking order theory (Cosh and Hughes, 2003), and therefore less likely to obtain an optimal capital structure (Hussain et al., 2006). The capital structure is also influenced by macro-economic conditions as banks tend to reduce lending during a recession or credit crunch (Berggren, 2009).
The capital structure of a firm is also influenced by its size. Small businesses typically start with capital from owners’ personal funds, family and friends (Kuratko and Hornsby, 2009). External investors are less keen to invest in small businesses because of issues related to the poor corporate governance mechanisms (Talmor and Vasvari, 2011). The above-mentioned difficulties in raising external equity mean that smaller businesses are more bank dependent than larger businesses (Carbo-Valverde et al., 2009).
The capital structure of a firm is also affected by governance determinants, such as manager ownership, board composition, and ownership concentration (Iona et al., 2008). An analysis of firms in the UK from 1984 to 2001 showed that financially conservative firms tend to have a gearing level less than the optimal gearing (Iona et al., 2008). Firms with high manager ownership are expected to have lower gearing as managers try to reduce the risk from financial leverage or else they may lose a substantial percentage of their personal wealth if the business goes bankrupt due to its inability to make interest payments.
There are a few fallacies associated with capital structure. The first is that leverage increases earnings per share, and therefore increasing debt will increase the value of the firm (Berk and DeMarzo, 2014). This argument assumes that the price-to-earnings multiple will remain same at high leverage levels, which is not true as high debt increases the financial risk of a firm.
The second fallacy is that equity should not be issued as it results in dilution of ownership (Berk and DeMarzo, 2014). While the issue of equity to external investors dilutes ownership if existing owners do not subscribe to new shares, new equity can have a positive impact on the value of shareholding of existing investors if it is invested in positive net present value projects.
Test your understanding
- Since the cost of debt is usually cheaper than the cost of equity, does including more and more debt reduce the average cost of capital of a firm?
- What is the key factor that makes debt attractive in the capital structure of a business?
- Identify two companies in the construction industry and assess their capital structure? Is the cost of debt of the company that is more geared higher than the firm that is less geared? Why or Why not?
The two main categories of capital in a business are equity and debt. The formulae for calculating costs of equity and debt, and weighted average cost of capital (WACC) are discussed in this section.
The Capital Asset Pricing Model (CAPM) determines the expected cost of equity as a function of a single factor, the systematic risk of the firm (Lajoux & Monks, 2010). The following equation is used for calculating the cost of equity:
Cost of equity = Risk-free rate + β*(Market return - Risk-free rate)
Where, beta (β) measures the relative risk of a share with respect to the stock market (Megginson & Smart, 2008). Beta of a listed company can be measured by regressing its share price returns against the market returns. The main stock market index in a country is used as a proxy of market when determining beta and the cost of equity.
Beta = Covariance between share price returns and market returns / Variance of market returns
Some studies, such as by Fama and French (1993) have found that the assumption of risk of a share being governed by market risk is not correct and results in insufficient returns. They argue that cost of equity should be modified to include other factors, such as the size of a business.
The risk-free rate in CAPM is the yield on a long-term government bond, typically with a 10-year maturity.
The difference between market return and risk-free return is called as market premium. Market premium for calculating the expected cost of equity can be calculated by using historic averages. Some studies, such as those by Fernandez et al. (2015) used a survey of academics and market participants to estimate the market premium.
Cost of debt is the annualised interest charged by lenders. For a firm with multiple debts with different interest rates, the cost of debt is the weighted average of interest rates, which is weighted by the amount of loan outstanding for each debt. Where interest rates are not mentioned, the following formula can be used to determine the cost of debt:
Cost of debt = Interest paid in a year / (Debt at the start of the year + Debt at the end of the year)/2)
The interest paid by a firm is tax deductible, which reduces the net cost of debt.
Net cost of debt = (1 - Tax rate)*Cost of debt
The WACC of a business reflects the weighted costs of different sources of finance used in the capital structure of a firm. The WACC without tax is calculated as per the following formula:
WACC without tax = Cost of Debt *(Debt/Value of firm) + Cost of Equity*(Equity/Value of firm)
The interest paid by a firm is tax deductible, which reduces the net cost of debt. The WACC with tax is calculated as per the following formula:
WACC with tax = Cost of Debt *(1-Tax rate)*(Debt/Value of firm) + Cost of Equity*(Equity/Value of firm)
The value of a firm is the sum of its debt and equity. For a listed company, equity is the market value of its shares, which is calculated by multiplying its share price by the number of outstanding shares. For unlisted companies, book value of equity can be used in calculating WACC.
Test your understanding
Choose a company from the FTSE 250 and obtain data on daily market returns for the company and for the index for 3 years. Use the data to calculate the cost of equity using capital asset pricing model. Compare the results with the actual cost of equity. Are there any variations? Why or why not?
The two main sources of finance are debt and equity. They differ in their risk-return profile, which are discussed to highlight their advantages and disadvantages in a capital structure of a firm.
The cost of debt is less than equity (McLaney, 2006), which increases the value of a business by reducing its weighted cost of capital. However, debt financing has disadvantages too. Debt provided by banks is often limited to 85% of the face value of assets (Timmons et al., 2004), which means that businesses have to arrange finance from other sources to fund the remaining cost of acquisition. In order to safeguard their principal, lenders place covenants, which can restrict a firm in terms of investments it can make (Miller, 1988). The cost of debt increases at higher levels of financial gearing due to lower margin of safety available to lenders if a business goes bankrupt (Shubita and Maroof alsawalhah, 2012). The bankruptcy risk is also higher because the borrowing firm must make regular interest and principal payments (ICAEW, 2012).
Equity can be raised by issuing shares to family and friends, venture capitalists, private equity firms and initial public offerings. The main benefit of issuing equity is that a firm does not have to make regular payments to shareholders (Pratt, 2010), which reduces bankruptcy risk in an environment of lower profits. The lower seniority of equity, compared to debt, means that the cost of equity is higher. Issuing equity to external shareholders dilutes ownership of existing owners if the latter does not subscribe to additional shares.
The main sources of long-term finance are debt and equity. The benefits and limitations of these two sources were discussed above.
The main sources of short-term finance are overdraft, accounts receivable financing and suppliers credit.
Businesses also use interest-free credit given by suppliers to finance their working capital (ICAEW, 2012). Suppliers use credit term to attract businesses. Supplier credit is the most economical form of external financing as suppliers do not charge interest if they are paid within the agreed credit period. Customers need to balance interest-free period against discounts offered by suppliers for early payment.
Banks provide overdraft facility to businesses to finance their working capital. Overdraft is expensive than long-term finance, but it gives flexibility to a business in terms of amount and duration of borrowing. However, overdraft can be withdrawn at a short notice, and hence exposes firms to greater risk from re-financing.
Factoring or invoice discounting can be used to finance accounts receivables. Typically, 70-85% of value of account receivables can be financed on invoices outstanding for less than 90 days (Timmons et al., 2004). The lender takes control of the collection process in factoring, which may sometimes damage client relationship if the factoring firm is less sensitive to the client-supplier relationship.
The choice of finance sources is also dependent upon the nature of assets being financed. It is advisable to finance long-life assets with long-term source of finance to avoid the problem of regular re-financing (Hingston, 2001), which means that non-current assets should be financed with debt and/or equity. Short term assets, such as working capital, should preferably be financed with sources which can be easily drawn and repaid to minimise interest expense on non-utilised funds.
A business may acquire long-term asset with short-term financing or funding short-term assets with long-term sources of finance if it believes that interest rates may change in the short/medium term. External equity finance, especially venture capital, is also highly susceptible to cyclical fluctuations with low financing during recession (Berggren, 2009).
Test your understanding
True or False
- Overdraft is a long-term source of finance?
- The proportion between debt and equity in the capital structure is always determined by the advantages and disadvantages of various source of finance?
The share price of a company is sum of the present value of the future cash flows to shareholders. If a firm only pays dividends to its shareholders, the DDM calculates the share price of a company as sum of the present values of its future dividends (ICAEW, 2012). Calculation of the present value of the future dividends means that share price in the DDM requires an estimation of both future dividends and cost of equity, since dividends are discounted by the cost of equity. The following formula is used for calculating share price in the DDM:
Share price = ∑ Expected dividend in period t / Expected cost of equity
The issue with the dividend discount model is that it assumes that dividend is the only way to create value for shareholders, which is not always the case as some companies show strong appreciation in share price without paying dividends. Apple and Microsoft did not pay dividends till many years after becoming hugely profitable, yet their market capitalisation increased. Also, estimating future dividends of a start-up loss making business is difficult, but this does not mean that the business has no value.
Another issue with the dividend based valuation is that it does not into account the money returned to shareholders via share repurchase. The decision to return cash to shareholders via share purchase is influenced by dividend policies of a firm, and is discussed later.
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One version of the DDM is the Gordon’s dividend growth model which assumes constant growth in dividends in the future (ICAEW, 2012). The underlying principle in the Gordon’s constant dividend growth model is that management of a firm uses dividends as a signalling tool to inform investors about future earnings. Investors will find it difficult to estimate earnings, therefore earnings-dependent dividend, in a fast-changing business environment. Management’s adoption of a constant dividend growth model helps investors in estimating future dividends, thereby avoiding discount which would be applicable when investors do not have clarity about future earnings. Gordon’s constant dividend growth model calculates share price as per the following formula.
Share price = Expected dividend in the next period / (Expected cost of equity - Constant dividend growth rate)
Dividend policy describes the choices that management of a firm makes about distributing cash to shareholders (Graham et al., 2010). Dividend policy has been subject of many studies, but it remains among the top ten most difficult unsolved problems in finance (Brealey et al., 2011), and there is a lack of consensus on why firms pay dividends (Baker, 2009). No single theoretical model has found support in dividend policies of all companies. The main dividend policies are discussed below:
- Dividend irrelevance hypothesis
Miller and Modigliani (1961) initially stated that dividends do not impact shareholders’ wealth, and thus dividend policy is irrelevant. This analysis was based on perfect market conditions, and Bhattacharya (1979) argued that those were not valid in real market conditions.
- Bird-in-the-hand hypothesis
The "bird-in-the-hand" hypothesis explains dividend decision on the fact that investors assign higher value to dividend payments than unrealised capital gains (Bhattacharya, 1979). However, investors can easily generate cash by selling shares, but their actions are restricted by disproportionate transaction costs when selling smaller quantity of shares.
- Signaling theory
Managers tend to know better about their businesses than investors, which results in information asymmetry between managements and investors. This can cause investors to discount future earnings of a business and/or an increase in cost of capital. The signaling hypothesis states that managers can reduce information asymmetry by using dividends to communicate information about their businesses (Neale and McElroy, 2004). Investors analyse the trends in dividends to understand expectations of managements about the future earnings (Aharony and Swary, 1980). Good corporate governance, including greater voluntary disclosures, reduce information asymmetries, thereby limiting the incremental benefits from dividend signaling (Dunn and Mayhew, 2004).
- Agency theory
The agency costs theory implies that firms with large cash holdings should pay high dividends to shareholders to reduce concerns of the latter regarding the misuse of cash (Nyberg et al., 2010). The problem with increasing dividend to reduce agency costs is that external investors cannot differentiate whether this is good or bad for the company (Easterbrook, 1984). A poorly managed firm may increase dividends to hide inefficiency of its management, which will disguise the true position of the business.
- Tax effect hypothesis and Clientele effect
Dividend income is taxed, which causes the division of investors into dividend tax clienteles depending upon their maximum tax rates. If the capital gains tax rate is less than dividend tax then investors would prefer lower payment of dividend, and vice-versa. It may result in investors with lower capital gains tax rate investing more in high growth companies than in high dividend paying companies.
Individual investors may also design their portfolios that have particular dividend paying characteristics to satisfy their particular needs, an aspect known as the ‘dividend clientele effect’ (Hussainey et al., 2011). Investors preferring regular income may prefer dividend paying firms. If a firm decides to lower dividends to increase capital investments, some investors may sell their shares. If many investors do this simultaneously, it may cause a decline in share price of the company. Given the large number of investors with capital gain or dividend preference, it is unlikely that the dividend clientele effects share price.
- Pecking order hypothesis
This hypothesis suggests that the internally generated capital is least subject to the problem of information asymmetry, and therefore management would prefer internal capital for financing investments before raising external capital (Jensen, 1986). The implication of the pecking order theory for dividend policy is that the dividend decision is secondary to financing and investment decisions. This is not supported in empirical studies as Brav et al. (2005) found that management believe that maintaining the dividend level carries same weight as investment decisions.
- Catering theory
Baker and Wurgler (2004) argued that a stock price premium could appear on dividend paying firms, which means that non-dividend paying firms may revisit their dividend decision to cater to the investor demand in order to capture this ‘‘dividend premium.’’ Empirical evidence does not support this at the macro level. The percentage of dividend paying firms in the U.S. has declined substantially in recent decades, which implies lower stock premium for dividend paying firms (Baker and Wurgler, 2004).
The two main dividend policies are constant dividend payout and constant dividend growth. These two policies are designed to reduce information asymmetry between managements and investors. Dividend in a constant dividend payout policy is calculated as a ratio of earnings per share, and the ratio remains constant or similar over the years. This policy is suitable for firms with mature business and less variance in earnings, as otherwise it would be difficult for investors to estimate dividend for a business with high fluctuations in earnings.
The second dividend policy is the constant dividend policy, where a company increases dividend payments at the same or similar rate each year. This policy is useful for companies which have high variations in earnings, and thus it is difficult for their investors to estimate the dividend payment if a constant dividend pay-out policy is not adopted.
Share repurchase is another form of returning cash to shareholders. Companies with considerable excess cash, more than what they need to invest and pay dividends, may use share repurchase to purchase shares from existing shareholders. This approach allows firms to provide a return to shareholders without changing their dividend policy. If the same cash is returned through dividends, the company must pay high dividends in the future also to maintain dividend growth. Thus, share repurchase allows firms to return excess cash to shareholders without worrying about its impact on future dividends.
Announcement of a share repurchase decision is likely to have a positive impact on share prices as it implies that the balance sheet of the firm is strong, and it also reduces agency problem between management and investors. It may have a negative impact on share prices of high growth companies as it gives a signal that the management is running out of value-adding investments.
Agency problem refers to the conflict of interest in a relationship where one party is expected to act in best interests of another party but fails to do so. The agency problem in corporate finance typically refers to a conflict of interest between management and the owners of a company.
Managers are typically different from owners in public listed firms and other businesses where ownership is widely distributed, and act as agents of shareholders to look after the economic interests of owners in a firm (Jensen and Meckling, 1976). While it is managers’ fiduciary duty to look after interests of shareholders, separation of ownership from control could result in conflict of interest between shareholders and managers if managers put their personal interest ahead of those of shareholders (Nyberg et al., 2010).
Management of a firm facing agency problem is more likely to retain excess cash in the business rather than return it to its shareholders through dividend payments and/or share buybacks, even if there are not sufficient number of good investment opportunities (Bates et al., 2009). Myers and Rajan (1998) found that managers of bigger firms enjoy more private benefits than those of smaller firms, and hence managers may favour holding cash to increase their benefits at the expense of shareholders. Management may justify holding high amounts of excess cash based on potential M&A opportunities and/or investments in business. Excess cash in a business may force its management to invest in negative NPV projects, which will destroy value for shareholders. Therefore, shareholders in firms with agency problem would prefer its management to distribute the excess cash to them, in form of regular and special dividends, to prevent shareholder-management conflicts (Stulz, 1990). This means that management should use external financing for funding acquisition and investment. Raising capital from external sources increases public scrutiny of businesses, which acts as a control mechanism to limit management’s investment in negative NPV projects.
Agency problem can also arise between managers and lenders as managers may favour shareholders by investing in high-risk projects which reduces value of the security given to lenders. Lenders impose covenants, such as maximum gearing ratio or minimum interest coverage ratio to reduce the agency conﬂict between them and managers (Ovtchinnikov, 2010).
Corporate governance systems are helpful in mitigating agency problems in firms. The Combined Code of Corporate Governance of the UK lists many governance mechanisms, such as independent board and auditors, and committees made up of independent directors, to monitor performance of managers which is helpful in reducing agency conflicts between shareholders and managers (Clacher et al., 2010, p. 141). Monitoring of managers forces them to invest in value-enhancing projects and to reduce personal perks, thereby causing an increase in cash flows investors (Renders et al., 2010).
Test your understanding
Obtain an annual report of a FTSE 250 company. Analyse its dividend policy over past 10 years. Is the movement in share price of the company explained by the dividend policy adopted by the business? If not, list out the reasons that may explain the movement in the share price and the factors explaining the dividend policy adopted by the firm.
Is paying out dividends a good mechanism of signalling to the shareholders that a business is performing well?
Mergers and acquisitions differ in terms of the relative size of two companies, post-transaction ownership of the combined business by shareholders of two companies and management control of the combined business (Coyle, 2000). In the case of a merger, companies are of similar sizes and the ownership of the merged entity is split almost equally between the shareholders of the two merged firms (McGrath, 2011), whereas acquiring firms control substantially more than 50% of the combined firm in an acquisition (Lee and Lee, 2006).
According to Dunning and Lundan (2008), corporate motives of M&A are acquisition of resources and strategic assets, and increase in market share and efficiency. Gaughan (2011) states that the main motive of M&A is to increase growth in profit through higher sales and market power. Cross-border M&A are useful in increasing sales if home country sales growth rates are low (Bahadir et al., 2008). Firms also engage in M&As to acquire technological resources and capabilities for further growth and improve efficiency (Sudarsanam, 2003). Acquisition of a firm in sectors other than the main operating sector of a business could be driven by the acquiring firm’s desire to reduce risk through diversification (Oberg and Holtstrom, 2006).
Managers can also push for M&A for their private benefits which are linked to firm size (Sudarsanam, 2003). M&A between firms in two different sectors can reduce volatility of cash flows of the combined firm, and thus improve job security of managers (Huyghebaert and Luypaert, 2010). Roll (1986) argues that hubris, which is over-confidence of managers in their skills, as another managerial rationale for M&A. M&A transactions typically happen in merger waves as businesses consolidate their position in view of increase in size of one of their competitors. Merger waves are also driven by personal motives of managers since clustering of M&A transactions reduce the negative long-term impact of unsuccessful acquisitions on the reputation of managers since the blame is shared with other managers (Duchin and Schmidt, 2013).
Performance of M&A can be analysed by share price returns and accounting performance. Shareholders of target firms earn substantial returns, whereas shareholders of acquiring firms receive either negative or slight positive returns (Fuller et al., 2002). Shareholders of target firm earn positive abnormal returns in order to persuade them to sell their shares. The abnormal share price returns of bidding firm depend upon the mode of payment and size of the firm. Abnormal returns of the acquiring firm are negative when the method of payment is stock rather than cash, since shareholders of target firms believe that the acquiring firm is more likely to offer its shares in exchange of their shares when shares of the acquiring firm are over-priced (Faccio and Masulis, 2005).
An issue with analysing performance after M&A is how to define and measure success. One of the most commonly used success measure of M&A is the usage of accounting performance (Hoskisson et al., 1994). In a study of all merged firms globally from 1995 to 2010, it was found that 43% of them reported lower profits than comparable non-merged firms (Banal-Estanol and Seldeslachts, 2011). This and other empirical studies suggest that the majority of M&A have not delivered value to the shareholders of the acquiring firm as per the expectations (Prayag, 2005).
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M&A fail due to many reasons, such as insufficient due diligence, over-valuation, unclear strategic plan and inexperience in integration of companies (Haransky, 1999). Adolph and Neely (2006) argue that most mergers fail at the integration stage. Honore and Maheja (2003) suggest that lack of oversight in culture and communication is one of the main contributors to failure in cross-border M&A. The premium paid to acquire a firm impacts the returns of the acquiring firm with high premium linked to lower share price returns (Díaz et al., 2009).
A lease is an agreement that gives the lessee the right to use an asset, but lessor has the legal ownership of asset (Alexander et al., 2009). There are two main categories of leases - finance and operating. In a finance lease, all risks and rewards associated with the asset are transferred substantially to the lessee (Elliott and Elliott, 2008). Leases which are not classified as finance leases are called operating leases. The classification of a lease as finance or operating depends upon a set of accounting criteria. Leases where lease term is closer to the useful life of an asset are finance leases.
Leases are a substitute of debt. In an operating lease, the lessee does not have to disclose the liability on its balance sheet, which means that it can be treated as off balance sheet financing. The exclusion of operating lease from balance sheet results in understatement of liabilities, and hence can be used by a management to show better financial position (Christodoulou, 2009). A firm can sell its assets and then lease them back. Proceeds from asset sale can be used to reduce debt, which shows better financial position, whereas in reality the company still has future obligations. According to Pollack (2013), only a small proportion of leases are reported on a lessee’s balance sheet. This creates problems for investors who adjust liabilities of the firm by adding back the obligation for future operating lease payments on a lessee’s balance sheet.
Test your understanding
Which of the following is a key factor driving mergers and acquisitions?
- Improve growth prospects
Identify 5 mergers/acquisitions after 2010 and evaluate the most common way through which merged or acquired entities are able to benefit from synergies i.e. reduced combined operational cost?
List the differences in the accounting treatment between operating and financing lease?
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