Financing decision

Index

1. Introduction

2. Financing Strategies
2.1 Aggressive Financing Strategy
2.2 Conservative Financing Strategy
2.3 The Middle-of-the-Road Strategy/ Moderate Strategy
2.4 Comparison of the Different Approaches

3. Theories to Determine the Optimal Capital Structure of a Firm
3.1 The Net Income Approach
3.2 The Net Operating Income Approach
3.3 The Traditional Approach
3.4 The Contemporary Approach

4. Leverage: Analysing its Effect
4.1 Operating Leverage and Financial Leverage
4.2 Different Degrees of Financial Leverage at a Given Level of EBIT
4.3 Trade Off Between Risk and Return
4.4 The Effect of Leverage on the Firm Value
4.5 Factors Influencing the Choice of Financial Structure
4.6 Factors to Account for before Considering Leverage
4.7 Effect of debt on liquidity and solvency

5. The Modigliani Miller Theorem
5.1 Maximizing Firm Value vs. Maximizing Stockholder Interest
5.2 Modigliani Miller Proposition I (without tax)
5.3 Modigliani Miller Proposition II (without tax)
5.4 Effect of Taxes
5.5 Tax Shield and Present Value
5.6 Value of the Levered Firm
5.7 Expected Return and Leverage

6. Conclusion

7. References p.

Abstract

This paper will focus on the optimal combination of debt and equity capital and how this decision influences the value of the firm. It will discuss financing strategies, theories to determine the optimal capital structure, leverage and the Modigliani Miller Theorem. We conclude that financing decisions do have an effect on the firm and that an optimal capital structure does exist.

1. Introduction

The financing strategy is the mix of capital chosen by each enterprise (Conrad 1999:456). This strategy is of extreme importance, because it can have a profound effect on the value of the enterprise (Conrad 1999:456). In general, firms have different possibilities to design its capital structure. Debt can be issued in a large quantity or only in a small amount. Furthermore, warrants, convertible bonds, caps, callers or preferred stock can be issued. Firms can use lease financing, bond swaps or forward contracts (Miller 1988). The variations in capital structures are infinite, due to the endless number of financing instruments.

Variables such as demand and supply, the capital requirement, the price of capital (interest rates), types of security, etc. are given at a particular point in time. We will discuss how a firm should finance in order to establish an optimal combination of equity and debt capital in the interests of the welfare of the owners. Uncertainty and risk are central to the financing problem and therefore financing must in essence be dynamic by nature. The single most important basis for making any financial decision is prognosis. The techniques used are mainly those of budgets and analysis by means of ratios (Lambrechts 1990: 511,512).

Prognosis, income expectations and developments in the money and capital markets, play a central role as the single most important basis of each financing decision (Lambrechts 1990: 512). The optimal combinations of equity capital and debt to maximise the interest of the owners, are achieved by means of the sensible use of debt. The question thus arises to what extent this approach can be utilised and therefore the determining factors of the financial structure must be considered in more detail.

This paper will focus on these factors. It will not discuss sources of financing in detail, which should be treated as a separate topic.

2. Financing Strategies

A firm can opt for one of three financing strategies: an aggressive financing strategy, a conservative financing strategy or a middle-of-the-road or moderate strategy (Gitmann 2000:619; Lambrechts 1990:513; Maness & Zietlow 1998:510).

2.1 Aggressive Financing Strategy

The aggressive strategy is used to fund at least all of the firm’s seasonal requirements and some of its permanent requirements with short-term debt (Gitmann 2000:620; Lambrechts 1990:514; Maness & Zietlow 1998:511). The aggressive strategy has a cost advantage because the financing cost of short-term debt is normally cheaper than long term debt (Gitmann 2000:622 and Maness & Zietlow 1998:512). This strategy draws heavily on the enterprise’s short-term borrowing capacity and negatively influences its liquidity (Maness & Zietlow 1998:512). Thus if an unforeseen expense comes along the firm may not be able to acquire the necessary financing for it (Gitmann 2000:622).

Example:

If an enterprise’s permanent financing requirement is R 14 000 and its seasonal requirements range from R 0 to R 4 000 with an average seasonal requirement of R 2 000, its financing cost is going to be:

Abbildung in dieser Leseprobe nicht enthalten

2.2 Conservative Financing Strategy

With the conservative strategy all financing requirements are financed with long-term debt and short-term financing is reserved for emergencies or unexpected outflows of funds (Gitmann 2000:622). This strategy is more expensive than the previous for two reasons: Firstly, long term financing cost is higher than short-term and secondly the firm borrows funds for the whole period regardless if it is needed (Gitmann 2000:623). Here the enterprise does not over- exceed its short-term borrowing capacity and thus it is available for emergencies (Gitmann 2000:624). The firm has excess liquidity (Maness & Zietlow 1998:512). With this strategy it is possible to reduce financing cost by reinvesting the excess amount of long term debt in the months that it is not required (Conrad 1999:456).

Example:

Using the same figures as in the above example the maximum financial requirements of the enterprise will be R 18 000. With the conservative approach the enterprise borrows the maximum amount needed during the year for the total year.

Abbildung in dieser Leseprobe nicht enthalten

2.3 The middle-of-the-road strategy/ Moderate strategy

This is a blend of the previous strategies (Lambrechts 1990:515 and Maness & Zietlow 1998:512). The combination depends on the risk preferences of the companies and also the current market conditions (Maness & Zietlow 1998:512).

2.4 Comparison of the different approaches

When deciding on the type of strategy the enterprise is going to follow, the risk and profitability aspect of each of the strategies should be evaluated. The following table provides a summary of the strategies and the factors.

Abbildung in dieser Leseprobe nicht enthalten

(Lambrechts 1990:516 and Maness & Zietlow 1998:511-512)

Most of the sources conclude that an optimal capital structure exists, but that no formula exists to calculate the optimal capital structure (Anderson & Groth 1997: 558; Correia, Flynn, Uliana and Wormald 1993:583). Prof I.J. Lambrechts provides a formula for the optimum split between long term and short term financing in the capital structure (Lambrechts 1990: 516). If long term debt can be reinvested, a portion of a firm’s capital requirements can be financed more cheaply with long term debt than with short-term debt. This can be calculated with the following formula:

Abbildung in dieser Leseprobe nicht enthalten

where k1 is the effective cost of long term debt, PL is the long term rate per year, PK is the reinvestment rate earned on the long term debt when it is not used and n is the period when the firm uses the long term debt (Lambrechts 1990: 516-517).

If the effective cost of long term debt for a period is less than the cost of short term debt, long term debt is to be used (Lambrechts 1990: 518). The period where the cost of long term and short term debt is equal can be calculated with the following equation:

Abbildung in dieser Leseprobe nicht enthalten

Where PS is the cost of short term debt (Lambrechts 1990: 518). This period is called the critical period (Lambrechts 1990: 518). For the critical period the firm should use short term debt as financing and for the period longer than the critical period, long term debt should be used (Lambrechts 1990: 518).

3. Theories to Determine the Optimal Capital Structure of a Firm

Financing decisions are dependent on a firm’s capital structure. The optimal capital structure of a firm is the debt to equity ratio a company uses to minimize the weighted average cost of capital (WACC), thus maximizing the firm’s value (Anderson & Groth 1997: 553-554; Correia, Flynn, Uliana and Wormald 1993:58; Gitmann 2000:516, Damodaran 1999: 226-227 & Harris & Jalilvand 1984:129). The optimal capital structure determines the firm’s financial risk and how operating income is split between shareholders (Chow, Gritta & Hockstein 1988:37). There are five theories to determine the optimal capital structure of a firm (Correia, Flynn, Uliana and Wormald 1993:583). These approaches are the net income approach, the net operating income approach, the traditional approach, the Modigliani - Miller approach and the contemporary approach (Correia, Flynn, Uliana and Wormald 1993:583). Approaches one to three and approach five will be covered briefly in the following section. The Modigliani - Miller approach will be discussed later in this paper since it is the most widely used approach (Anderson & Groth 1997: 553).

3.1 The Net Income Approach

This approach presumes that debt capital is a cheaper form of finance than equity capital. Firstly because debt capital is less risky than equity capital so the investor expects a lower return and secondly because the interest payments on debt capital is tax deductible (Correia, Flynn, Uliana and Wormald 1993:583). It is assumed that the cost of the debt and equity capital remains the same as the amount of financing increases and that there is no company tax (Correia, Flynn, Uliana and Wormald 1993:583). These assumptions are not realistic. The net income approach shows that the

weighted average cost of capital declines with the use of more debt financing and thus that the value of the firm increases (Correia, Flynn, Uliana and Wormald 1993:583).

3.2 The Net Operating Income Approach

The net operating income approach relaxes the assumption that the cost of equity capital remains the same as financial leverage increases, but it still assumes that the cost of debt and WACC remains constant (Correia, Flynn, Uliana and Wormald 1993:584). This approach insinuates that the choice of the capital structure is irrelevant since the change in leverage has no effect on the value of the enterprise (Correia, Flynn, Uliana and Wormald 1993:584, Damodaran 1999: 239-240). The Modigliani-Miller paper, “The cost of capital, corporation finance and the theory of investment”, published in 1958 supports this approach (Damodaran 1999: 239-240).

3.3 The Traditional Approach

This approach is a compromise between the previous two approaches. It states that up to a certain point leverage has no effect on the cost of debt and equity. The increasing use of debt capital increases the risk of the enterprise and thus at a certain point the shareholders will demand a higher return on their investment increasing the cost of equity and WACC (Correia, Flynn, Uliana and Wormald 1993:586). The point where WACC start rising is the optimal capital structure (Correia, Flynn, Uliana and Wormald 1993:586)

3.4 The Contemporary Approach

The contemporary approach states that the increase in the cost of equity and debt capital is minimal at the beginning, but the bigger the increase in debt capital, the bigger the increase in the cost (Correia, Flynn, Uliana and Wormald 1993:591). This results in WACC falling slightly in the beginning, then remaining constant for a range of capital structures and then increasing again (Correia, Flynn, Uliana and Wormald 1993:591). The main difference between the Modigliani- Miller approach and the contemporary approach is that this last approach considers a whole range of capital structures to be optimal (Correia, Flynn, Uliana and Wormald 1993:591).

Most of the above-mentioned approaches have been formulated in perfect market conditions. With relaxed assumptions market imperfections come into play. The effect of corporate taxes, agency costs and bankruptcy costs implies that financing decisions do have an effect on the firm and that an optimal capital structure does exist (Harris & Jalilvand 1984: 128).

4. Leverage: Analysing Its Effect

After discussing financing strategies and theories to determine the optimal capital structure of a firm, we can now continue the analysis of the financing decision by studying leverage. Even if it is common to borrow money to buy a car or a house, it is much less common to borrow money to invest. Financial leverage occurs whenever a firm finances with interest-bearing debt. The objective of analysing a company's financial leverage is to establish whether management is able to earn more on the debt funds than the funds cost. If so, then the firm realizes favourable financial leverage. If not, it earns unfavourable financial leverage. If a firm does not have any interest-bearing debt financing, it does not have any financial risk and cannot realize financial leverage (Gallinger, 2000).

Leveraging involves buying securities by using a portion of your own money and borrowing the rest. Borrowing more money allows you to make a larger investment. The more you invest, the greater the potential returns. However, leveraging can also result in increased losses. To understand this, consider the following explanations and numerical examples.

4.1 Operating Leverage and Financial Leverage

John Pringle and Robert Harris define operating leverage in terms of the relationship between fixed and variable operating expenses. The termoperatingrefers to expenses related to the firm’s operations and include all expenses except interest and taxes. The higher a firm’s ratio of fixed to variable operating costs, the higher its operating leverage. Contrasted with operating leverage, financial leverage refers to the mix of debt to equity. Firms using a lot of debt is said to be highly leveraged. The degree of leverage can be measured in one of the following terms:

- Stock terms - by using the ratio debt to equity.

- In flow terms - by using the ratio of interest payments to earnings before interest and tax (EBIT).

Operating leverage determines the extent to which a change in sales revenue affects EBIT. Operating leverage is sometimes referred to as first stage leverage (Weston and Copeland, 1986: 558). On the other hand, financial leverage has no effect on EBIT, because interest payments on debt come after the calculation of EBIT on the income statement. Financial leverage determines the effect that changes in EBIT have on shareholders (Pringle and Harris, 1984: 479). Financial leverage is also referred to as second stage leverage.

The degree of financial leverage can be defined as the ratio of the percentage change in net income available to common stockholders that is associated with a given percentage change in EBIT:

Abbildung in dieser Leseprobe nicht enthalten

4.2 Different Degrees of Financial Leverage at a Given Level of EBIT

As is now known, financial leverage is dependent on two variables, namely the ratio of total capital to equity capital and the ratio of income before and after interest. Thus, the leverage factor is:

Abbildung in dieser Leseprobe nicht enthalten

The interest rate in fact acts as a leverage factor and there could be a positive or negative influence up or down as more or less debt capital is used, and as ROA and Rd (interest rate on debt) varies. With ROA = Rd, there is no leverage since ROE = ROA; with ROA > Rd, leverage is positive and ROE > ROA (Lambrechts, Brummer, 1990: 520).

Consider a firm with assets of R1000 that can be financed in one of the following three ways: · entirely by equity

- 30 percent debt and 70 percent equity

- 60 percent debt and 40 percent equity

Assume the debt can be financed at a rate of 8% and the equity has a market price of R10 per share. Also presume that the R1000 assets generate an EBIT of R240 (i.e. 24% rate of return), and the tax rate is 50%.

[...]