Reference 10
1.0 Introduction
“Capital Structure is a combination of a company’s debt which is consisting of long term debt and short term debt, common equity and preferred equity.” (Ross et al, 2006) In other words, the concept of capital structure is how companies finance its overall operations and growth using different sources of available funds. Debt usually comes in the form of bond issues or long term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short term debt such as working capital requirements is also considered to be part of the capital structure.
In the Australian context, Bruce et al (1989) indentified a number of important considerations when measuring a firm’s capital structure. The ratio debt-to-equity as a source of information about the firm is important, as is the relative cost of debt to equity, the mixture of short and long-term liabilities and the appropriate level of off-balance sheet financing.
1.1 Company Background
Caltex Australia Limited, founded in 1900 with it’s headquarter in Sydney, Australia, is the largest refiner and marketer of petroleum products in all states and territories in Australia. The company is the only oil refining and marketing company which listed on the Australian Stock Exchange. Together with its subsidiaries, Caltex Australia Limited major activities including refining, supply, purchase and selling petroleum products, transporting fuel and also engaging in the operation of convenience stores around Australia.
The company owns and operates petroleum fuel refineries, including The Kurnell refinery and The Lytton refinery, with a combined capacity of approximately 35 million liters per day. It also owns and operates 11 seaboard storage terminals, as well as a pipeline of approximately 200 kilometers from the Kurnell refinery in Sydney to the Wickham terminal in Newcastle. The company’s pipeline carries a range of fuel products, including petrol, diesel, and jet fuel.
Caltex Australia Limited operates its own fleet of road tankers to transport the cartage of refined products from terminals to service stations, distribution depots, and commercial end users. The company also has a fleet of dedicated rail tank cars. In addition, it manufactures and markets specialty products, such as bitumen, gases, and waxes. Caltex Australia Limited markets its products to commercial and industrial customers in the mining, industrial, aviation, and transport sectors through distribution channels, including retail, wholesale, and commercial. It has a 50% interest in the joint venture with Vitalgas Pty Limited, a retailer of liquid petroleum gas.
Source: Caltex Australia Limited 2007 Annual Report
1.2 Purpose
The purpose of the report is to examine Caltex Australia Limited’s current financial data, abstracted from the company’s annual report to determine whether the existing ratio of debt-to-equity is at an optimal level.
1.3 Aim
The aim of this report is to analyze the data abstracted from the financial report and generate a set of recommendations of what action Caltex Australia Limited can undertake to move the current capital structure into an optimal level.
1.4 Scope
The report will be based on the concept of debt-to-equity ratio to justify the current capital structure. In addition to that, the concept of static theory of capital structure, tax shield, and cost of capital, financial distress and financial leverage will be further discussed and applied in the report.
2.0 Optimal Capital Structure
“The problem of optimization of corporate structure is one of the central problems of corporate finance and has important applications for practical decision making concerning financing of current operations and investment projects of corporations.” (Philosophov, L. V., Philosophov, V. L., 2005) According to Kraus & Lizenberger, 1973, optimal proposition of stockholders own and borrowed capital must balance out positive properties of debt, following from the existence of tax shelter and its negative properties consisting in increase of bankruptcy risk as a share of debt capital increases. “An optimal capital structure usually involves some debt, but not purely 100% debt.” (Ross et al, 2006) Ordinarily, it is hard for firms to identify the optimal point precisely, but, firms should try to find an optimal range for the capital structure. Optimal capital structure (Petty et al, P. 448) is described as being the capital structure that minimizes the firms composite cost of capital for raising a given amount of money. Specifically, ensuring that depending upon the nature of the investment the right mix of funding is achieved; short term asset is financed with short term debt, while long term asset is financed with long term debt.
Hallinan, E. (2004), stated that companies finance their operations with some combination of debt and equity, and many investment decisions the company makes needs to take into account the cost incurred to obtain those dollars. A company’s proposition of short and long term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is highly levered.
According to Hovakimian, A., Opler, T., Titman, S., (2001), a debt-to-equity ratio represents optimal capital structure while the value of a firm is maximized by minimizes the overall cost of capital which including capital of debt and capital of equity. Each of them has separate and distinct cost which can be determined by the Weighted of Average Cost of Capital (WACC), by combining the weighted average cost of both types of capital, debt and equity, weighted according to their proportion to each other. However, there is risk characteristics associated with the each of the cost. In general, a firm can finance its operations through debt financing or equity financing. Firms may prefer debt financing due to the fact that interest on debt is tax-deductible which lower the borrowing cost, lower acquisition cost and the risk is lower due to legal protections and possible collateral available.
3.0 Analysis of Debt-to-Equity Ratio
“Debt to equity ratio is a measure of a company’s financial leverage calculated by dividing its total liabilities by shareholders equity” (Godfrey, J. M., 2006). It indicates what proportion of equity and debt the company is using to finance its assets. A high debt to equity ratio generally means that a company has been aggressive in financing its growth with debt. “Since interest payments to lenders are tax deductible from taxable income, while dividend payments to shareholders are not, tax systems typically encourage the use of debt rather than equity finance” (Aggarwal, R., Kyaw, N. A., 2004)
3.1 Capital Restructuring
Capital restructuring involves the process of raising debt to finance the return of capital to shareholders accompanied by a new dividend policy that maintains the desired level of financial leverage. “Recapitalization depends upon the market value of the business, the financial flexibility needed to meet on-going capital requirements, unplanned investment opportunities and to weather unforeseen adverse trading conditions, and the optimal borrowing structure which involves the mix of fixed rate and floating debt rate, maturity structure, the borrowing sources, covenants and banking relationships.” (Lowe, J., Naughton, T., Taylor, P., 1994)
3.2 Effect of Capital Reconstruction on Debt/Equity
Notes: 1 Issued Capital at 31/12/2007 was 270,000,000 ordinary shares of $2
2 Issued Capital post reconstruction is 243,000,000 ordinary shares of $2
3 Issued Capital post reconstruction is 216,000,000 ordinary shares of $2
For the purpose of determining how a reconstruction of debt-to-equity leads to an increase in earnings per share and return on equity, two scenarios have been set up. The first scenario is based on 10 percent of increment in debt while the second scenario is based on 20 percent of increment in debt. Such a construction would involve returning between 20 cents and 40 cents to shareholders for each share they are presently entitled to.
Assumptions:
1. Interest rate is based on 8 percent per annum.
Scenario 1: 10% increase in debt
According to the data generated in scenario 1, with an increment of a further 10 percent of debt, which is approximately, $54 million, the firm will incur an extra $5 million of interest expense while such reconstruction will also generate a return of 20 cents from paid up capital to shareholders. Issued capital will then be reduced to 243 million ordinary shares of $2 each. This has resulted in an increase in debt-to-equity ratio, which is from 0.21 to 0.23. The profit after tax in this structure is approximately, $616 million. Therefore, the earnings per share based on 243 million ordinary shares have increased from 2.29 to 2.53 and the return on equity has increased from 21% to 22%.
Scenario 2: 20% increase in debt
As for the data generated in scenario 2, with an increment of a further 20 percent of debt, which is approximately, $108 million, and the firm will incur an extra $9 million of interest expense while such reconstruction will also generate a return of 40 cents from paid up capital to shareholders. Issued capital will then be reduced to 216 million ordinary shares of $2 each. This has resulted in an increase in debt-to-equity ratio, which is from 0.21 to 0.26. The profit after tax in this structure is approximately, $616 million. Therefore, the earnings per share based on 216 million ordinary shares have increased from 2.29 to 2.83 and the return on equity has increased from 21% to 23%.
3.3 The Interest Tax Shield
Based on the data generated, it can be seen that the total cash flow obtained in scenario 1 is 1.5 million more and scenario 2 is 2.7 million more. The fact that interest is deductible for tax purposes has generated a tax saving of equal to the interest payment of 5 million in scenario one multiplied by tax rate of 30 percent which is equal to 1.5 million of tax shield, and 9 million in scenario two multiplied by tax rate of 30 percent which is equal to 2.7 million of tax shield.
- Static Theory of Capital Structure
The static theory of capital structure says that firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress “The idea behind this static theory is that it assumes that the firm is fixed in terms of its assets and operations and it only considers possible changes in the debt/equity ratio.” (Ross et al, 2007)
4.1 Taxes
Tax advantage is connected to the use of debt financing form one of the main factors, predetermining the existence of the optimal capital structure. “When ratio of total debt to stockholders equity is small, its increase leads to a proportional increase of a firm’s value because of tax shelter effect.” (Philosophov, L. V., Philosophov, V. L., 2005) Further increase of share of debt capital increases the probability of a firm’s bankruptcy and thus reduces its value. At a certain value of the debt-to-equity ratio, the negative effect of debt balances out its positive effect.
Tax benefits from leverage is obviously only important to firms that are in a tax paying position. Firms with accumulated losses will get little value from interest tax shield. Furthermore, Ross et al (2005) added that firms that have substantial tax shields from other sources such as depreciation will get less benefits from leverage.
4.2 Financial Distress
Firms with a higher risk of experiencing financial distress will borrow less than firms with a lower risk of financial distress. In other words, the greater volatility in earnings before income tax (EBIT), the less the firm should borrow, because of a higher exposure to risk. In addition, financial distress is more costly for some firms than others. The cost of financial distress depends primarily on the firm’s assets. In particular, financial distress costs will be determined by how easily ownership of the assets can be transferred or turn into cash, in other words, how liquid is the asset. For example, (Ross et al, 2006) a firm with mostly physical assets that can be sold without great loss in value will have an enticement to borrow more and as for firms that rely heavily on intangibles such as employee talent or growth opportunities, debt will be less attractive because these assets effectively cannot be sold.
5.0 Recommendations
Based on the data generated, higher debt-to-equity ratio leads to higher earnings per share and higher return on equity as compared to a low debt-to-equity ratio. In addition to that, the findings also established that the interest tax shield is crucial in the sense that it brings down the pre-tax cost of debt, therefore reduces the weighted average cost of capital. Therefore it is recommended that Caltex should undertake more debt in order to maximize shareholders wealth. However, the level of increment should be at a level when tax saving from an additional dollar in interest just equals the increase in expected financial distress cost. This is due to the fact that the possibility of financial distress increase as the level of debt grows.
6.0 Conclusions
According to Ross et al, (2007), the ideal mixture of debt and equity for a firm is its optimal capital structure, which is the one that maximizes the value of the firm and minimizes the overall costs. The effect of the company taxes makes the capital structure matters a great deal. This conclusion is based on the fact that interest is tax deductible and thus generates a valuable tax shield. However, the cost of financial distress reduces the attractive of debt financing. That is why it is crucial for the management should make sure that tax saving from an additional dollar in interest just equals the increase in expected financial distress cost. In addition to that, it is crucial for companies to use a combination of tools to establish a proper type of capital structure.
References
Aggarwal, R., Kyaw, N. A., (2004), “Internal Capital Markets and Capital Structure Choices of U.S. Multinationals’ Affiliates,” Working Paper, Hagan School of Business
Caltex Australia Limited, 2007, Annual Report, Australia, Accessed 15th August 2008 <http://www.caltex.com.au/annualreports/2007/index.html>
Godfrey, J. M., (2006), “Accounting Theory,” 6th edn, John Wiley & Sons, Milton, Queensland
Hallinan, E., (2004), “The Cost of Capital and Capital Structure”, Reeves Journal, vol. 84, no. 11, p. 56
Hovakimian, A., Opler, T., Titman, S., (2001), “The debt-equity Choice”, Journal of Financial and Quantitative Analysis, vol. 36, no. 1, p. 1
Lowe, J., Naughton, T., Taylor, P., (1994), “The Impact of Corporate Strategy on the Capital Structure of Australian Companies”, Managerial and Decision Economics, vol. 15, pp. 245-257
Petty, W. J., Peacock, R., Martin, P., Burrow, M., Keown, A. J., Scott, D. F., Marin, J. D., (1996), “Basic Financial Management”, Prentice Hall, Australia
Philosophov, L. V. & Philosophov V. L., (2005), “Optimization of a firm’s capital structure: A quantitative approach based on probabilistic prognosis of risk and time of bankruptcy”, International Review of Financial Analysis, vol. 14, pp. 191-209
Ross, S. A., Westerfield, R. W., Jordan, B. D., (2006), “Fundamentals of Corporate Finance”, 7th edn, McGraw-Hill Irwin, New York
Ross, S., Thompson, S., Christensen, M., Westerfield, R., Jordan, B., (2007), “Fundamentals of Corporate Finance”, 4th edn, McGraw-Hill Irwin, New South Wales
