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Capital Structure: Debt Financing

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Question:

Discuss about the Capital Structure for Debt Financing.
 
 

Answer:

Leverage Implication for Debt Financing

Debts are borrowed money from creditors and when companies take on debt, they are said to be leveraged. In other words, highly leveraged organizations are those that pursue relatively high amounts of debt. Although, debt represents an obligation towards creditors, it is helpful for existing owners due to the effect of financial leverage. Furthermore, defaulting on a loan can result in bankruptcy and financial distress, especially if the company is highly leveraged, and is encountering problems paying off various creditors. Even so, debt is regarded as a major financing choice because when companies utilize debt to offer further capital for their business activities, equity owners gain an opportunity to keep extra profits generated through the debt capital, after payment of interests (Horngren, 2013). Equity investors possess a higher equity return due to additional profits offered by debt financing, given the same equity amount. Besides, debt represents how risks are borne by shareholders and therefore, debt financing enhances the risk shareholders must encounter in reducing the stock price on a per-share basis. Thus, all things being equivalent, the highly leveraged stock price of a company is lesser than a company with relatively low leverage (Williams, 2012).

Decomposition of ROE model, also called DuPont Analysis is an expression that breaks Return on Equity into three different parts. This analysis assists an analyst to understand the origin of inferior or superior return by comparison with organizations in similar businesses. The ROE ratio is a measure of the rate of return to the shareholders. Decomposing the ROE into several factors plays a key role in influencing the performance of a company. It presents ratios utilized in fundamental evaluation. Firstly, the tax burden of company is Net Income / Pretax Profit. This is the profit proportion retained after payment of income taxes. Secondly, the interest burden of a company is pretax gain / EBIT (Guerard, 2013). This indicates firms with no financial leverage or debt. Thirdly, the Return on sales of a company is EBIT / Sales. Fourthly, the asset turnover of a company is Sales / Assets. Fifthly, the leverage ratio is Assets / Equity. Lastly, the compound leverage factor is Interest burden * Leverage. Therefore, after decomposition of ROE model, the equation comes to:

The leverage implications for EPS is that financial leverage can enhance such EPS as long as the after tax expense of the debts are less than the return on investment on the borrowed money. Moreover, as the debt equity ratio enhances, the risk of leverage also enhances and any alteration in the situation of company can cause the leverage to possess a negative influence. Besides, if the return on equity of a company declines, it must still cover the interest expense of debt that means a more pronounced decline in earnings per share than if there were less leverage (Horngren, 2013). A high degree of leverage depicts that the EPS of a company is more volatile. For instance, if company ABC has an EBIT of $50 million, interest cost of $15 million and outstanding shares of 50 million in the first year. The outcome of ABC’s EPS comes to 70 cents ($50 million - $15 million) / (50 million). In the second year, if ABC has EBIT of $200 million, interest expense of $25 million and outstanding shares of 50 million. The resulting EPS comes to $3.50 ($200 million-$25 million) / (50 million). On a whole, the resulting financial leverage of ABC comes to 1.33 (($3.5 - $0.7)/$0.7) / (($200 million - $50 million)/$50 million). Hence, if the EBIT of the decreases or increases by one percent, the degree of financial leverage portrays that its EPS increases or decreases by 1.33%.

 

Capital Structure Theory

Capital structure theory is a key in taking any management decision regarding the equity and debt mix of the organization. Wherein the intent of every management is to increase the benefit to the shareholders of the organization, however, it has both good effect and a bad effect attached with the same. Though increasing the debt in the capital structure helps in reducing the tax payments as the interest being paid on the debt taken by the organization is a deductible expenditure while computing the tax payable of the organization but it creates an obligation on the management to pay high interest which in long term becomes difficult for the organization to continue with the same (Laux, 2014). This leads in bankruptcy. As the obligation becomes difficult for the organization to meet, it ultimately leads in non- payment of interest as well as the debt taken by the organization. On the other hand side if there is no tax benefit attached with the debt being taken then the organization will obviously be interested in meeting its capital requirements by increasing the equity i.e. by raising share capital structure of the organization. This would definitely lower the bankruptcy rate as the organization will not be under pressure to repay the debt and the fund of the shareholders will be used for the meeting the capital requirements of the organization.

There are various theories having different implications. One of it is signaling theory which is an important tool in considering the debt equity mix for the capital structure as is an organization would increase the equity then it would indirectly send a signal to the investors that the organization may be facing liquidity issues and also it results in diluting the share value. On the other hand if the organization raises debt to fulfill its requirement and the organization is unable to meet the repayment of debt then credit rating will be downgraded which would send a bad signal to the investors. However, debt is usually preferred over equity. As per the constraining managers theory the management tries to reduce the cash flow but a risk arises if the managers are unable to service the debt on time and the organization becomes bankrupt it automatically results in the managers losing their job which is a bad decision of the management (Williams, 2012). Pecking order hypothesis theory states that the capital requirements of an organization should be met through the income generated by the organization, then it should use the funds by selling it short term marketable securities, if more funds are required then the organization should take debts from the market, then it should issue the preferential shares in the market and get money through this only after that it should raise money through the issue of equity shares in the market.  According to windows of opportunity theory, an organization waits for the right time when it can get a particular at a right rate. This helps the investors in understanding that the management is trying to keep the costs low. Overall it has been understood that taking debt from the market is always better than raising fund through issue of equity. 

Debt Choices

Making this choice between debt and equity and how much debt to carry in the books is an important decision for each company. This factor is also highly affected by the kind of industry that the firm is.  Firms with low inventory and high cash business requires less debt as they need not invest in high infrastructure and hence less debt. Debt is usually needed to invest in long term asset creation (Fields, 2011). This long term effect of the debt has a direct bearing on the asset-liability equation of the company and has to ensure that liquidity does not go bust. Another factor affecting the choice of debt is the firm's credit rating, size, market-to-book ratio, profitability, degree of leverage, and tangible assets.

Some industries make a lot of use of debt – such as airlines, real estate, utilities and financial services (such as banks). The reason is that the main asset or selling point of these firms is aircrafts, buildings and land, loans respectively which cannot be bought directly and is usually leased and rented out. This creates the debt component on the balance sheet (Fields, 2011). For example telecommunications industry needs to build towers across the landscape to ensure connectivity, purchase spectrum during government auctions as these are its assets which create the services. Thus these companies carry a high Debt-equity ratio and it is important to note the importance of this number along with a few other indicators (Brealey et.al, 2014).

These companies will have a high fixed interest rate and a high financial leverage. Normally industries such as services go with the acceptable debt –equity ratio of 1 -1.5 that is Liabilities/Equity. Capital intensive industries need a higher number in its normal operation – usually more than 2. This is generally accepted debt- equity typical of each industry.

Generally a high debt-to-equity ratio indicates a company’s inability to satisfy its debt obligations. However a very low debt-equity might also indicate that the company is not taking advantage of its financial leverage available to it.  Also, industries like airlines which make use of operating leases are allowed by accounting laws to keep the capital leases as an off-balance sheet item but the right way to look at debt is to add these to the debt in the balance sheet as they are similar to debt in nature. Among them are aerospace and defense, along with those companies which are manufacturers of general building materials and farm and construction machinery (Graham & Smart, 2012). The average debt-to-equity ratio for the industrial goods sector can be as high as 1.90. The average for the services industry was 1.6 and the average for utilities was 1.40.

The finance sector's average debt-to-equity ratio in the U.S was an eye-popping 2.6 in 2015. Within the sector, the mortgage investment industry showed an average of 8.9. This huge disparity between debt and equity for financial companies when compared to other industries is not a cause for concern. As discussed, a financial company such as a bank borrows money at a lower rate and lends the money at a higher rate, making a profit on the spread between the two (Leo, 2011). Hence it is important to take care of such nuances while looking at companies’ financial positions.

Companies need to issue bonds and prefer that rather than sell additional shares because of the lower cost of debt, as also because interest payments are tax deductible. Issuing additional shares also dilutes the fractional ownership of shareholders and can affect and halt managerial decisions (Albrecht et. al, 2011). What matters is whether the company invests the proceeds from its borrowing into projects that generate a return above its cost of capital. It is important to study the background of the industry, its operating environment and its nuances to really understand if a particular firm is carrying excess debt or following the norm.

 

References

Albrecht, W., Stice, E. & Stice, J. (2011).  Financial accounting. Mason, OH: Thomson/South-Western.

Brealey, R, Myers, S. & Allen, F. (2014). Principles of corporate finance. New York: McGraw-Hill/Irwin.

Fields, E. (2011). The essentials of finance and accounting for nonfinancial managers, New York: American Management Association.

Graham, J. & Smart, S. (2012).   Introduction to corporate finance. Australia: South-Western Cengage Learning.

Guerard, J. (2013). Introduction to financial forecasting in investment analysis. New York, NY: Springer.

Horngren, C. (2013) Financial accounting. Frenchs Forest, N.S.W: Pearson Australia Group.

Laux, B. (2014). Discussion of The role of revenue recognition in performance reporting.  Accounting and Business Research, 44(4),  380-382.

Leo, K. J. (2011). Company Accounting, Boston:McGraw Hill

Williams, J. (2012). Financial accounting. New York: McGraw-Hill/Irwin.

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