Introduction
There are two ways to raise capital either from equity or debt. Within these methods are a further set of options. For example if we were to raise the capital via the equity route we could investigate solutions such as issuing new shares (ordinary or preferred), retained earnings, warrant bonds or convertibles. On the debt side there are a variety of ways including bank loans, debentures (unsecured long term loans) and bonds.
A Marketing Problem?
The process of raising finance, defining a debt policy, can be seen as fundamentally a marketing problem. The final solution being the one that most appeals to investors and the market i.e. the one that increases their wealth. This debt policy and the impact on the dividend policy all have a part to play when it comes to the shareholders wealth. This was not the proposition put forward by Miller and Modigliani (Brearly and Myers,2000:476) in their classic 1961 article where they referred to “the irrelevance of dividend policy in a world without taxes, transaction costs, or other market imperfections”. A model based on the assumption of perfect and efficient capital markets. This theory implies that gearing is irrelevant. That is not the market place the company is today facing.
Pecking order theory states that investment should first be funded by retained earnings, then new debt and finally by raising new equity. This is based on the idea of asymmetric information where managers are more knowledgeable than investors.
Company’s value is determined by its assets not by the securities it issues. If that was true then all equity financing is the right decision. The view is far too simplistic.
Debt
Advantages
Payments regarded as cost and therefore tax deductible. Government providing a tax subsidy on the use of debt. Interest is tax deductible and thus generates additional value. As long as the interest tax shields can be used. For this to take place the company must be making profit.
Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure.
Figure 1 The tax benefit of debt financing
Adds discipline to management – separation between managers and shareholders Forcing a company to borrow can reduce management complacency
Quick to organise
Disadvantages
When arranging debt financing the company will have to pay agency costs. These costs cover the Covenants – as seen above Charge over the fixed assets
the Cost: arrangement fee and interest payments are largely at variable companies current debt can be hedged, so their exposure to climbing interest rates will be limited.
Increases the financial risk due to the relationship with variables interest rates which then impacts the expectancy of the shareholders to higher rates of return on their investment
Agency costs
Financial Distress
Possible financial distress should limit borrowing – especially for risky companys. The higher the debt ratio more likely to fall into financial distress if a serious recession hits the economy.
Bankruptcy costs
There are two elements to bankruptcy costs. First there is the cost, direct and indirect. Direct includes legal and other deadweight costs and indirect as the company is perceived to be in financial trouble. The second element is the probability of bankruptcy which will depend on the certainty of future cash flows. The expected bankruptcy costs is therefore directly correlated to the increase in probability of bankruptcy.
Increases the expected rate of return on shareholders investment as debt financing creates financial risk for shareholders
Fail to make payments you lose control of the business
Loss of future flexibility and therefore if the company is not sure what it may want to do in the future it should use less debt.
Alternative Approaches
Financing via retained earnings
This option has the advantage of being the line of least resistance. What the company has to be careful in regarding is when there are these shifts in capital structure this sometimes forces important decisions about dividend policy. If the earnings are going into a project investment that means they are not available to pay out as dividends. The fact that this is happening will then impact share price. The impact of which can be limited by providing as much forewarning as possible so as to make sure the action is not misinterpreted.
Others benefits of using retained earnings is of control and flexibility. Managers stay in control of their business. That is to say there are no restrictions by covenants or dividend cover.
Financing via a Rights Shares
The announcement of a new equity issue is usually bad news for investors as it may signal bad news with regard to future profits or higher risk. In this companies case the risk is not really changing in that the company will still be in the same core business.
A company is limited to a maximum no of shares that can be issued. This is known as authorised share capital and is specified in the articles of association. Should the company not be able to raise as much as it requires it would have to obtain the agreement of the shareholders in order to change the quantities.
Using this type of finance will reduce theUltimate control of the company’s affairs with voting rights on who sits on the board plus other matters.
Dividends paid out after-tax income
The cost of issuing new securities is high
Recommendation
Consider the influential factors that determine debt equity choice
How the company is currently geared
Potential tax benefits
Benefits of using debt as a disciplinary mechanism
Potential for agency costs
Need for financial flexibility
Debt funds stable cashflows and equity funds variable cashflow.
Traditional capital structure theory, long term assets are best funded with long term debt
The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate.
The investment is in to the same business the company is currently in
The company that is being consider is a retail company that is medium risk. The very fact that it already has stores I am assuming then that it does have a level of brand awareness. When a company has a level of brand awareness
A further issue that needs to be clarified is what level of financing to cover by debt The approach for answering this question can be based on various concepts adjusted present value approach, looking at other companies in the same business sector and timescales.
The adjusted present value approach takes the company’s value as being the value it has without any gearing plus the tax benefits of the debt minus the expected bankruptcy cost from the debt. From this we then chose the debt level that maximises the company value.
The financing policy varies from industry to industry. For the market value of the company not to be affected following industry standards can limit any damage. Damodaran (2002) refers this to being the “safest” place for any firm. In Appendix 1 there is some research showing the level of gearing by other companies in the same industry. Looking at the data (although) limited shows a great range of gearing levels. The company needs to do is also take into account the current tax rate where the higher the tax rate the higher the debt ratio due to the tax benefits.
Lower insider ownership higher debt ratio (greater discipline)
More stable income …. Higher debt ratios (lower bankruptcy costs)
More tangible assets …. Lower debt ratios (more agency problems)
Timescales dependent on how quick the project was required to start we could start with using some retained profit whilst the debt from the bank is being renegotiated.
Match the debt cash flow with asset cash flow this has the impact of reducing our risk of not being able to pay the debt, increases our debt capacity (interest cover) and therefore this has the impact of increasing the company value.
Renegotiation of debt terms – dividend cover is double that of the industry average.
Restricting it to 30% to get anymore would increase the agency costs.
Retailing projects are tied to the store life
Stores via leases – if you have get out clauses in the lease these could be matched with the financing options.
Appendix 1 Industry gearing ratios, no employed and dividend cover
All the companies listed below are FTSE SmallCap in the General Retailer Sector
(2002) and Financial Times (2002)
References
Brealy, Richard A and Myers, Stewart C (2000), Principles of Corporate Finance. Sixth Edition Irwin McGraw-Hill
(2002).Financial Times January 14,p
Hemscott Net [WWW] http://businessplus.hemscott.net/backpage/index.htmaccessed (January 2 2002)
Rutterford, Janette ed.(1998), Financial Strategy Adding Stakeholder Value. John Wiley, England.
Samuels, J.M., Wilkes F.M. and Brayshaw R.E. (1990), Management of Company Finance. Chapman and Hall, London. Fifth Edition.
Schlendorf, Katja (2002), Infineon off 6% after bond issue. Financial Times, January 9, p.26.
Vaitilingham, Romesh (2001), The Financial Times Guide to Using The Financial Pages. Pearson Education Limited, England. Fourth Edition.
