Businesses 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.
M&M irrelevance theory of capital structure
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.
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.
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 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 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 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 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
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)
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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.
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. 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. 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.
Banks provide overdraft facility to businesses to finance their working capital. Overdraft is more expensive than long-term finance, but it gives flexibility to a business in terms of amount and duration of borrowing.
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.
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
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. Management’s adoption of a constant dividend growth model helps investors in estimating future dividends, 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)
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.
- 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).
- Signaling theory
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).
- 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).
- 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.
- Pecking order hypothesis
The implication of the pecking order theory for dividend policy is that the dividend decision is secondary to financing and 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’’.
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.
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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.
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.
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.
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).
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).
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).
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 the asset (Alexander et al., 2009). Leases are a substitute of debt.
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