PROJECT REPORT

ON
CAPITAL STRUCTURE DECISION

MASTER OF COMMERCE
(2015-2016)
ADVANCED FINANCIAL MANAGEMENT
UNIVERSITY OF MUMBAI

UNDER THE GUIDANCE OF

PROF. DHANABALU R. NAIKAR

SUBMITTED BY
MISS. REETU S. VISHWAKARMA
ROLL NO. 57
S.K. SOMAIYA COLLEGE OF ARTS,
SCIENCE &COMMERCE
VIDYAVIHAR (EAST)

S.K. SOMAIYA COLLEGE OF ARTS, SCIENCE & COMMERCE

VIDYAVIHAR (EAST)

CERTIFICATE
(2014-2015)
This is to certify that MISS. REETU S. VISHWAKARMA,
ROLL NO. 57 Of M.COM (II) (2015-2016) has successfully completed the
project on CAPITAL STRUCTURE DECISION under the guidance of
PROF. DHANABALU R. NAIKAR.
D ate:

(Dr. SANGEETA KOHLI.)

PRINCIPAL.

Place: Mumbai.

(Prof. RAVIKANT SANGURDE.)

COURSE CO-ORDINATOR.

(Prof. DHANABALU R. NAIKAR.)

PROJECT GUIDE/ INTERNAL EXAMINER .

EXTERNAL EXAMINER.

DECLARATION BY STUDENT

I, REETU S. VISHWAKARMA, ROLL NO. 57 , the

student of M.Com (II) ( 2015-2016) hereby declares that I have completed the
project on CAPITAL STRUCTURE DECISION successfully.

The information submitted is true and original to the best of

my knowledge.

Thank you,

Yours faithfully,
REETU S. VISHWAKARMA
Roll No.57

ACKNOWLEDGEMENT

I would like to thank all the people who helped me in undertaking the study and
completing the project, by imparting me with valuable information and
guidance that was required at every stage of my project work.

I would like to like to thank our Principal DR. SANGEETA KOHLI and our
course co-ordinator PROF. RAVIKANT SANGURDE , for giving me an
opportunity and encouragement to prepare the project.

Last but not the least, I would like to thank my project guide PROF.
DHANABALU R. NAIKAR for guiding and helping me throughout the
preparation of my project, right from the selection of my topic till its
completion.

INDEX
1.
2.
3.
4.
5.
6.
7.
8.

INTRODUCTION...............................................................................................
DEFINITION.......................................................................................................
MEANING...........................................................................................................
CAPITAL STRUCTURE OF A COMPANY......................................................
FACTORS INVOLVED IN CAPITAL STRUCTURE.......................................
FEATURE OF OPTIMAL CAPITAL STRUCTURE.........................................
CONSTRAINTS IN DESIGNING OPTIMAL CAPITAL STRUCTURE..........
APPROACHES TO ESTABLISH AN APPROPRIATE CAPITAL

06
09
10
11
13
15
16

STRUCTURE......................................................................................................... 17
9. CAPITAL STRUCTURE IN A PERFECT MARKET.........................................
19
10. CAPITAL STRUCTURE IN THE REAL WORLD.............................................
20
11. CORPORATE FINANCE- FACTORS THAT INFLUENCE A COMPANYS
CAPITAL STRUCTURE DECISION..................................................................
12. CAPITAL STRUCTURE AND RISK RETURN TRADEOFF..........................
13. MAJOR PARTICIPANTS IN SECURITIZATION PROCESS...........................
14. ADVANTAGES AND DISADVANTAGES OF CAPITAL STRUCTURE

22
26
27

DECISION...........................................................................................................
15. CAPITAL STRUCTURE OF INTERNET COMPANIES: CASE STUDY.......
16. CONCLUSION....................................................................................................
17. REFERENCES.....................................................................................................

33
37
59
60

INTRODUCTION
In traditional corporate finance, the objective in decision making is to maximize the value of
the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded
and markets are viewed to be efficient, the objective is to maximize the stock price. Stock
price maximization, firm value maximization and stockholder wealth maximization is not the
5

same. Stock price maximization is the most restrictive of the three objective functions. It
requires that managers take decisions that maximize stockholder wealth, that bondholders be
fully protected from expropriation, that markets be efficient and that social costs be
negligible. Stockholder wealth maximization is slightly less restrictive, since it does not
require that markets be efficient. (Damodaran, 1994) Firm value maximization is the least
restrictive, since it does not require that bondholders be protected from expropriation. Thus,
when we make the argument that an action by a firm (such as investing or financing)
increases firm value, this increase in firm value will necessarily translate into increasing
stockholder wealth and stock price only if the more restrictive assumptions hold. Conversely,
an action that increases the stock price in a world where the less restrictive assumptions do
not hold, may not necessarily increase firm value.
The capital structure decisions of firms have important consequences at both the micro and
macro-level. At the micro-level, considerable research effort has gone into examining the
determinants of capital structure (see Harris and Raviv, (1991) for a review). Moreover,
within firms themselves substantial resources go into setting capital structure policies. At the
macro-level, several authors have maintained that corporate debt increases the vulnerability
of an economy to a downturn, with interest in this area having been further heightened by
marked increases in corporate indebtedness in the late-1990s (see IMF (2003) for a
discussion). This view of an important role for debt in influencing the macro economy dates
back to Fisher (1932) with the more recent literature on financial frictions in macroeconomic
models also emphasising its role in the business cycle (e.g. Bernanke et al. (1999)). How do
companies determine their capital structures? The two most influential theories of capital
structure are the trade off and pecking order theories. The first, the trade off model, argues
that companies trade off the benefits of additional debt (tax deductibility of interest expenses,
reduced agency costs of free cash flow) against the costs (bankruptcy risk) and at the margin
equate the two. The second approach, the pecking order model, argues that adverse selection
issues in raising funds by different methods dominate other considerations in the trade off
model such that a hierarchy of funds results. Firms will use internal funds first, then debt and
only when such options are exhausted will they resort to using new equity finance. The paper
first highlights the financial deficit of firms. Separate work (Benito and Young, 2001, 2002;
Benito, 2002) considers the behaviour of each component that makes up the financial deficit.
In this paper, the behaviour of corporate indebtedness itself and its response to certain
components of the financial deficit is considered, focusing on the different implications
under the pecking order and trade off models for how debt responds to the cash flow and
6

investment components of the financial deficit. At this point the study draws on previous
work by Fama and French (2002) in contrasting the empirical implications of the two central
models of capital structure, but relaxing the assumption of exogeneity of the key regressors,
controlling for firm-specific fixed effects and presents independent evidence on this subject
for firms operating in two different financial systems. The Spanish financial system has been
categorised as bank-based whilst that of the United Kingdom as market-based (e.g.
Demirg-Kunt and Maksimovic (1999, 2002). Does empirical support for either model
depend on the nature of the financial system? This is a further question considered in the
paper. Broadly reflecting the different nature of the financial systems in Spain and the United
Kingdom, as well as the nature of the samples available, the analysis then examines different
The capital structure decisions of firms have important consequences at both the micro and
macro-level. At the micro-level, considerable research effort has gone into examining the
determinants of capital structure (see Harris and Raviv, (1991) for a review). Moreover,
within firms themselves substantial resources go into setting capital structure policies. At the
macro-level, several authors have maintained that corporate debt increases the vulnerability
of an economy to a downturn, with interest in this area having been further heightened by
marked increases in corporate indebtedness in the late-1990s (see IMF (2003) for a
discussion). This view of an important role for debt in influencing the macro economy dates
back to Fisher (1932) with the more recent literature on financial frictions in macroeconomic
models also emphasising its role in the business cycle (e.g. Bernanke et al. (1999)). How do
companies determine their capital structures? The two most influential theories of capital
structure are the trade off and pecking order theories. The first, the trade off model, argues
that companies trade off the benefits of additional debt (tax deductibility of interest expenses,
reduced agency costs of free cash flow) against the costs (bankruptcy risk) and at the margin
equate the two. The second approach, the pecking order model, argues that adverse selection
issues in raising funds by different methods dominate other considerations in the trade off
model such that a hierarchy of funds results. Firms will use internal funds first, then debt and
only when such options are exhausted will they resort to using new equity finance. The paper
first highlights the financial deficit of firms. Separate work (Benito and Young, 2001, 2002;
Benito, 2002) considers the behaviour of each component that makes up the financial deficit.
In this paper, the behaviour of corporate indebtedness itself and its response to certain
components of the financial deficit is considered, focusing on the different implications
under the pecking order and trade off models for how debt responds to the cash flow and
investment components of the financial deficit. At this point the study draws on previous
7

work by Fama and French (2002) in contrasting the empirical implications of the two central
models of capital structure, but relaxing the assumption of erogeneity of the key regressors,
controlling for firm-specific fixed effects and presents independent evidence on this subject
for firms operating in two different financial systems. The Spanish financial system has been
categorised as bank-based whilst that of the United Kingdom as market-based (e.g.
Demirg-Kunt and Maksimovic (1999, 2002). Does empirical support for either model
depend on the nature of the financial system? This is a further question considered in the
paper. Broadly reflecting the different nature of the financial systems in Spain and the United
Kingdom, as well as the nature of the samples available, the analysis then examines different
features of these two financial systems. In the case of the Spanish bank-based system a
distinction is made between those firms where banks own equity in the firm and those where
banks do not own equity. This allows us to assess whether such a direct ownership stake
helps overcome asymmetric information that may give rise to the existence of the pecking
order. In the case of UK firms, use of public markets including new equity issues is relatively
more common. The pecking order model predicts that as well as being relatively rare, such
new equity issues should be less responsive to certain financial characteristics than the use of
additional borrowing. Under the pecking order model at the margin companies are more
likely to respond to variations in financial characteristics by varying their borrowing than by
issuing new equity. For the UK firms, this additional prediction of the pecking order model is
therefore considered. The remainder of the paper is organised as follows. Section 2
summarises the two main theoretical approaches and their empirical predictions. Section 3
presents data description for the company-level panel datasets. Section 4 presents estimation
results for company debt ratios, whilst section 5 considers a number of extensions.
Conclusions are presented in section 6.

DEFINITION of 'Capital Structure'

According to Gerestenberg, capital structure of a company refers to the composition or make
up of its capitalization and it includes all long term capital resources viz., loans, reserves,
shares and bonds. Keown et al. defined capital structure as, balancing the array of funds
sources in a proper manner, i.e. in relative magnitude or in proportions.
Capital structure refers to a companys outstanding debt and equity. It allows a firm to
understand what kind of funding the company uses to finance its overall activities and
growth. In other words, it shows the proportions of senior debt, subordinated debt and equity
(common or preferred) in the funding. The purpose of capital structure is to provide an
overview of the level of the companys risk. As a rule of thumb, the higher the proportion of
debt financing a company has, the higher its exposure to risk will be. Capital structure is
commonly known as the debt-to-equity ratio.
A mix of a company's long-term debt, specific short-term debt, common equity and preferred
equity. The capital structure is how a firm finances its overall operations and growth by using
different sources of funds.
Debt 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.

Meaning of Capital Structure

9

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. The capital structure involves two decisionsa. Type of securities to be issued are equity shares, preference shares and long term
borrowings (Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On this
basis, the companies are divided into twoi.

Highly geared companies - Those companies whose proportion of equity

capitalization is small.

ii.

Low geared companies - Those companies whose equity capital dominates

total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be USD
200,000 in each case. The ratio of equity capital to total capitalization in company A is USD
50,000, while in company B, ratio of equity capital is USD 150,000 to total capitalization,
i.e., in Company A, proportion is 25% and in company B, proportion is 75%. In such cases,
company A is considered to be a highly geared company and company B is low geared
company.
Capital structure refers to the portfolio of different sources of capital employed by a business.
It is the mix of capital. It is the portfolio of liabilities of business. It is the structure of long
term liabilities of a business. Short term liabilities being fluctuating type, for structure
analysis, which is some what long term in nature, are not considered for capital structure
analysis. There is another concept viz., financial structure which studies the structure of
whole of the liabilities of business including both short term and long term capital. In final
analysis, capital structure analysis is considered with the equity and debt composition of
capital of a business.

Capital Structure of a Company:

10

The assets of a company can be financed either by increasing the owners claims or the
creditors claims. The owners claim increase when the firm raises funds by issuing ordinary
shares or by retaining earnings; the creditors claims increase by borrowing. The various
means of financing represent the financial structure or capital structure of a company.
The term capital structure is used to represent the proportionate relationship between debt and
equity. Equity includes paid-up share capital, share premium and reserve and surplus
(retained earnings). The company will have to plan its capital structure initially at the time of
its promotion. Subsequently, whenever funds have to be raised finance investment, a capital
structure decision is involved. Capital structure of a company refers to the mix of sources
from where the long-term funds required in the business may be raised. A demand for raising
funds generates a new capital structure a decision has to be made to the quantity and forms of
financing. This decision will involve an analysis of the existing capital structure and the
factors, which will govern the decision at present. The companys policies to retain or
distribute earnings affect the owners claim. Shareholders equity position is strengthened by
retention of earning. The debt equity mix has implications for the shareholders earnings and
risk, which in turn will affect the cost of capital and the market value of the firm.
Patterns of the Capital Structure
In case of new company, the capital structure may be of any the following patterns:

Capital Structure with equity shares only.

Capital Structure with equity and preference.

Capital Structure with equity and debentures.

Capital Structure with equity, preference shares and debentures.

Debt is the liability on which interest has to be paid irrespective of the company profits.
While equity consists of shareholder or owners funds on which payment of dividend
depends upon the companys profit. A high proportion of the debt content in the capital
structure increases the risk and may lead to financial insolvency in adverse time. However,
raising fund through debt is cheaper as compared to financing through shares. This because
interest on debt is allowed as an expense for taxes purpose. Dividend is considered to be an
appropriation of profits; hence payment on dividend does not result in any tax benefit to the
company. This means if company, is in 50% tax bracket, pays interest at 12% on
11

its debentures, the effective cost to it comes only 6% while if the amount is raised by
12% Preference Shares, the cost of raising the amount would be 12%. Thus raising the funds
by borrowing is cheaper resulting in higher availability of profit for shareholders. This
increases the earning per share of the company, which is the basic objective of the finance
manager.
Optimum Capital Structure
A firm should try to maintain an optimum capital structure with a view of to
maintain financial stability. The optimum capital structure is obtained when the market value
per equity share is the maximum. It may be defined as that relationship of debt and equity
securities which maximizes the value of a companys share in the stock exchange. In case a
company borrows and this borrowing helps in increasing the value of companys share in the
stock exchange, it can be said that the borrowing has helped the company in moving towards
its optimum capital structure. In case, the borrowing results in fall in market value of the
companys equity shares, it can be said that the borrowing has moved the company from its
optimum capital structure.
The objective of the firm should therefore be to select the financing or debt equity mix, which
will lead to maximum value of the firm.
Consideration
The following consideration will greatly help a finance manager in achieving his goal of
optimum capital structure:

Take advantage of favourable financial leverage.

Take advantage of the leverage offered by the corporate taxes.

Avoid a perceived high risk capital structure.

12

Factors involved in capital structure :

What are the Components?

Senior Debt: A class of loans with priority on the repayment list if a company goes bankrupt.
Holders of this form of financing have first dibs on a companys assets. This means that in a
liquidation event, lenders holding subordinated notes are not paid out until senior creditors
are paid in full. Because of the minimal risk that accompanies this block of the capital
structure, senior lenders loan money at lower rates (i.e., lower interest payments and less
restrictive debt covenants) relative to more junior tiers.
Subordinated Debt: A class of loans that ranks below senior debt with regard to claims on
assets. For this reason, this block of the capital structure is more risky than senior borrowings.
However it also comes with commensurately higher returns, usually in the form of higher
interest payments. For more, see our piece on drivers behind the rebounding popularity of
subordinated debt.
Mezzanine Debt: A class of subordinated debt that blends equity and debt features. It
therefore receives liquidation after senior capital and is generally used when traditional
funding is insufficient or unavailable. Correspondingly, mezzanine firms lend at higher
13

interest rates than traditional debt providers, and usually reserve the right to trade some of
their debt for equity. Though mezzanine financing exhibits both equity- and debt-like
characteristics, its usually classified as a category within subordinated debt. For more details,
see our overview of mezzanine debt.
Hybrid Financing: A class of the capital structure in publicly-traded companies that also
blends equity and debt features. By definition, hybrid securities are bought and sold through
brokers on an exchange. Hybrid financing can come with fixed or floating returns, and can
pay interest or dividends.
Convertible Debt: A class of hybrid financing. Convertible bonds are the most common type
of hybrid financing, and usually take the form of a bonds that can be converted to equity. The
conversion can only happen at certain points in the firms life, the equity amount is usually
predetermined, and the act of converting is almost always up to the discretion of the debt
holder.
Convertible Equity: A class of hybrid financing. Convertible equity usually takes the form
of convertible preferred shares, which is preferred equity that can be converted to common
equity. Like convertible debt, convertible preferred shares convert into common shares at a
predetermined fixed rate, and the decision to convert is typically at the owners discretion.
Importantly, the value of a firms convertible preferred shares is usually dependent on the
market performance of its common shares.
Preferred Equity: A class of financing representing ownership interest in a company. As
opposed to fixed income assets (e.g., debt), equity is a variable return asset. However,
preferred equity has both debt and equity characteristics in the form of fixed dividends (debt)
and future earnings potential (equity). Correspondingly, it gives the holder upside and
downside exposure. Its claims on the companys assets and profits come behind those of debt
holders and ahead those of common stock holders. Generally, preferred equity obligates
management to pay its holders a predetermined dividend before paying dividends to common
shareholders. On the flipside, preferred equity typically comes without voting rights.
Common Equity: Also a class of financing representing ownership interest. Common equity
is the junior-most block of the capital structure and therefore represents ownership in an

14

business after all other obligations have been paid off. For this reason, it comes with the
highest risk and the highest potential returns of any tier in the capital structure.

Features of Optimal Capital Structure:

A sound or appropriate capital structure should have the following features:
Return: The capital structure of the company should be most advantageous. Subject to other
considerations, it should generate maximum returns to the shareholders without adding
additional cost to them.
Risk: The use of excessive debt threatens the solvency of the company. To the point debt
does not add significant risk it should be sued, otherwise its use should be avoided.
Flexibility: The capital structure should be flexible. It should be possible for a company to
adapt its capital structure with a minimum cost and delay if warranted by a changed situation.
It should also be possible for the company to provide funds whenever needed to finance its
profitable activities.
Capacity: The capital structure should be determined within the debt capacity of the
company and this capacity should not be exceeded. The debt capacity of a company depends
on its ability to generate future cash flows. It should have enough cash to pay creditors fixed
charges and principal sum.
Control: The capital structure should involve minimum risk of loss of control of the
company. The owners of closely-held companies are particularly concerned about dilution of
control.
The relationship of debt and equity in an optimal capital structure is made in such a manner
that the market value per equity share becomes maximum.
Optimal capital structure maintains the financial stability of the firm.
15

Under optimal capital structure the finance manager determines the proportion of debt and
equity in such a manner that the financial risk remains low.
The advantage of the leverage offered by corporate taxes is taken into account in achieving
the optimal capital structure. Borrowings help in increasing the value of company leading
towards optimal capital structure. The cost of capital reaches at its minimum and market price
of share becomes maximum at optimal capital structure.

Constraints in Designing Optimal Capital Structure:

The capital structure of a firm is designed in such a manner that the cost of capital is kept at
its lowest and the value of the firm reaches its maximum. The firm manoeuvres its debtequity proportion to reach the optimum level. However in practice, reaching the level of
optimum capital structure is a difficult task due to several constraints that appear on the way
of implementing that structure.
The main constraints in designing the optimum capital structure are:
1. The optimum debt-equity mix is difficult to ascertain in true sense.
2. The concept of appropriate capital structure is more realistic than the concept of optimum
capital structure.
3. It is difficult to find an optimum capital structure as the extent to which the market value of
an equity share will fall due to increase in risk of high debt content in capital structure, is
very difficult to measure.
4. The market price of equity share rarely changes due to changes in debt-equity mix, so there
cannot be any optimum capital structure.
5. It is impossible to predict exactly the amount of decrease in the market value of an equity
share because market factors that influence market value of equity share are highly complex.

16

Approaches to Establish an Appropriate Capital

Structure
The following are the 3 most common approaches to decide about a firms appropriate capital
structure:
1.

EBIT-EPS Approach- The EBIT-EPS analysis is an important tool in the hands of

the financial manager to get an insight into the firms capital structure management. He
can consider the possible fluctuations in the EBIT and examine their impact on EPS
under different financial plans. If the probability of earning a rate of return on the firms
assets less than the cost of debt is insignificant, a large amount of debt can be used by the
firm to increase the earnings per share. This may have a favourable effect on the market
value per share. On the other hand, if the probability of earning a rate of return on the
firms less than the cost of debt is very high, the firm should refrain from employing debt
capital. It may, thus, be concluded that the greater level of EBIT & lower the probability
of downward fluctuation, the more beneficial is to employ debt in the capital structure.
However, it should be realized that the EBIT-EPS is a first step in deciding about a firms
capital structure.

2.

Cost of Capital and Valuation Approach- The cost of a source of finance is the
minimum return expected by its suppliers. The expected return depends on the degree of
risk assumed by investors. A high degree of risk is assumed by the shareholders than the
17

debt-holders. In case of debt-holders, the rate of interest is fixed and the company is
legally bound to pay interest whether it makes profits or not. The loan of debt-holders is
returned within a prescribed period, while shareholders will have to share the residue
only when the company is wound up. This leads one to conclude that debt is a cheaper
source of funds than equity. The preference share capital is also cheaper than equity
capital, but not as cheap as debt.
3.

Cash Flow Approach- One of a feature of a sound capital structure is conservatism.

Conservatism does not mean employing no debt or small amount of debt. Conservatism
is created by the use of debt or preference capital in the capital structure and the firms
ability to generate cash to meet these fixed charges. The fixed charges of a company
include payment of interest, preference dividends, and the principal, and they depend on
both the amount of loan securities and the terms of payment. The amount of fixed
charges will be high if employs a large amount of debt or preference capital with shortterm maturity. The company expecting larger & stable cash inflows in the future can
employ a large amount of debt in their capital structure.

One important ratio which should be examined at the time of planning the capital structure is
the ratio of net cash inflows to fixed charges (debt- servicing ratio). It indicates the number of
times the fixed financial obligations are covered by the net cash inflows generated by the
company. The greater the coverage, the greater is the amount of debt a company can use.
How can financial leverage affect the value?
One thing is sure that wherever and whatever way one sources the finance from, it cannot
change the operating income levels. Financial leverage can, at the max, have impact on the
net income or the EPS (Earning per Share). The reason is explained further. Changing the
financing mix means changing the level of debts and change in levels of debt can impact the
interest payable by that firm. Decrease in interest would increase the net income and thereby
the EPS and it is a general belief that the increase in EPS leads to increase in value of the
firm.
Apparently, under this view, financial leverage is a useful tool to increase value but, at the
same time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy.
It is because higher the level of debt, higher would be the fixed obligation to honour the
interest payments to the debts providers.
18

Discussion of financial leverage has an obvious objective of finding an optimum capital

structure leading to maximization of value of firm. If cost of capital is high
Important theories or approaches to financial leverage or capital structure or financing mix
are as follows:
Net Income Approach: This approach was suggested by Durand and he was in the favour of
financial leverage decision. According to him, change in financial leverage would lead to
change in cost of capital. In short, if the ratio of debt in the capital structure increases, the
weighted average cost of capital decreases and hence the value of the firm.
Net Operating Income Approach: This approach is also provided by Durand but it is totally
opposite to the Net Income Approach. It says that the weighted average cost of capital
remains constant. It believes in the fact that the market analyses firm as a whole which
discounts at a particular rate which is not related to debt-equity ratio.
Traditional Approach: This approach is not defined hard and fast facts but it says that cost
of capital is a function of the capital structure. The special thing about this approach is that it
believes an optimal capital structure. Optimal capital structure implies that at a particular
ratio of debt and equity, the cost of capital is minimum and value of firm is maximum.
Modigliani and Miller Approach (MM Approach): It is a capital structure theory named
after Franco Modigliani and Merton Miller. MM theory proposed two propositions.
Proposition I: It says that the capital structure is irrelevant to the value of a firm. Value of two
identical firms would be same and it would not be affected by the mode of finance adopted to
finance the assets. Value of a firm is dependent on the expected future earnings.
Proposition II: It says that the financial leverage boosts the expected earnings but it does not
increase the value of the firm because the increase in earnings is compensated by the change
in the required rate of return.

Capital structure in a perfect market:Consider a perfect capital market (no transaction or bankruptcy costs; perfect information);
firms and individuals can borrow at the same interest rate; no taxes; and investment returns
19

are not affected by financial uncertainty. Modigliani and Miller made two findings under
these conditions. Their first 'proposition' was that the value of a company is independent of
its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged
firm is equal to the cost of equity for an unleveraged firm, plus an added premium for
financial risk. That is, as leverage increases, risk is shifted between different investor classes,
while total firm risk is constant, and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax
system, the tax deductibility of interest makes debt financing valuable; that is, the cost of
capital decreases as the proportion of debt in the capital structure increases. The optimal
structure , then would be to have virtually no equity at all, i.e. a capital structure consisting of
99.99% debt.

Capital structure in the real world:If capital structure is irrelevant in a perfect market, then imperfections which exist in the real
world must be the cause of its relevance. The theories below try to address some of these
imperfections, by relaxing assumptions made in the M&M model.

Trade-off theory:Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to
financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with
debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of
further increases in debt declines as debt increases, while the marginal cost increases, so that
a firm that is optimizing its overall value will focus on this trade-off when choosing how
much debt and equity to use for financing. Empirically, this theory may explain differences in
D/E ratios between industries, but it doesn't explain differences within the same industry.

Pecking order theory:-

20

Pecking Order theory tries to capture the costs of asymmetric information. It states that
companies prioritize their sources of financing (from internal financing to equity) according
to the law of least effort, or of least resistance, preferring to raise equity as a financing means
of last resort. Hence: internal financing is used first; when that is depleted, then debt is
issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory
maintains that businesses adhere to a hierarchy of financing sources and prefer internal
financing when available, and debt is preferred over equity if external financing is required
(equity would mean issuing shares which meant 'bringing external ownership' into the
company). Thus, the form of debt a firm chooses can act as a signal of its need for external
finance. The pecking order theory is popularized by Myers (1984). when he argues that
equity is a less preferred means to raise capital because when managers (who are assumed to
know better about true condition of the firm than investors) issue new equity, investors
believe that managers think that the firm is overvalued and managers are taking advantage of
this over-valuation. As a result, investors will place a lower value to the new equity issuance.

Agency Costs:There are three types of agency costs which can help explain the relevance of capital
structure.

Asset substitution effect: As D/E increases, management has an increased incentive

to undertake risky (even negative NPV) projects. This is because if the project is
successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get
all the downside.

Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a

growth company), the gain from the project will accrue to debt holders rather than
shareholders. Thus, management have an incentive to reject positive NPV projects, even
though they have the potential to increase firm value.

Free cash flow: unless free cash flow is given back to investors, management has an
incentive to destroy firm value through empire building and perks etc. Increasing
leverage imposes financial discipline on management.
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Structural Corporate Finance

An active area of research in finance is that which tries to translate the models above as well
as others into a structured theoretical setup that is time-consistent and that has a dynamic set
up similar to one that can be observed in the real world. Managerial contracts, debt contracts,
equity contracts, investment returns, all have long lived, multi-period implications. Therefore
it is hard to think through what the implications of the basic models above are for the real
world if they are not embedded in a dynamic structure that approximates reality. A similar
type of research is performed under the guise of credit risk research in which the modelling
of the likelihood of default and its pricing is undertaken under different assumptions about
investors and about the incentives of management, shareholders and debt holders. Examples
of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004).

Corporate Finance - Factors that Influence a Company's

Capital-Structure Decision
The primary factors that influence a company's capital-structure decision are:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business
risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail
apparel company. A utility company generally has more stability in earnings. The company has les
risk in its business given its stable revenue stream. However, a retail apparel company has the
potential for a bit more variability in its earnings. Since the sales of a retail apparel company are
driven primarily by trends in the fashion industry, the business risk of a retail apparel company is
much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors
feel comfortable with the company's ability to meet its responsibilities with the capital structure in
both good times and bad.

22

2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of
financing a project is attractive because the tax deductibility of the debt payments protects some
income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that
companies typically have no problem raising capital when sales are growing and earnings are strong.
However, given a company's strong cash flow in the good times, raising capital is not as hard.
Companies should make an effort to be prudent when raising capital in the good times, not stretching
its capabilities too far. The lower a company's debt level, the more financial flexibility a company
has. The airline industry is a good example. In good times, the industry generates significant amounts
of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a
position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a
decreased ability to raise debt capital during these bad times because investors may doubt the airline's
ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's
approach is, the less inclined it is to use debt to increase profits. An aggressive management may try
to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's
earnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing
money to grow faster. The conflict that arises with this method is that the revenues of growth firms are
typically unstable and unproven. As such, a high debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its revenues are stable and
proven. These firms also generate cash flow, which can be used to finance projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a
firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting
companies' access to capital because of market concerns, the interest rate to borrow may be higher
than a company would want to pay. In that situation, it may be prudent for a company to wait until
market conditions return to a more normal state before the company tries to access funds for the plant.
23

7. Size Of A Firm
There is a positive relation between the capital structure and size of a firm. The large firms are more
diversified, have easy access to the capital market, receive higher credit ratings for debt issues, and
pay lower interest rate on debt capital. Further, larger firms are less prone to bankruptcy and this
implies the less probability of bankruptcy and lower bankruptcy costs. Therefore, larger firms tend to
use more debt capital than smaller firms.
8. Growth In Sales
Anticipated growth rate in sales provides a measure of extent to which earning per share (EPS) of a
firm are likely to be magnified by leverage. The firm is likely to use debt financing with limited fixed
charge only when the return on equity is likely to be magnified. However, the firms with significant
growth in sales would have high market price per share as a result of which they might prefer equity
financing. The firm should make a relative cost benefit analysis against debt and equity financing in
anticipation to growth in sales to determine appropriate capital structure.
9. Debt Service Capacity
The higher debt level in capital structure increases the probability of bankruptcy and bankruptcy costs
of the enterprises. Probability of bankruptcy refers to the chances of cash flows to be less than the
amount required for servicing the debt. The debt service ratio measured by the ratio of operating
income to total interest charges indicates the firm's ability to meet its interest payment out of its
annual operating earnings. Therefore, the higher debt service ratio shows the higher debt capacity of
the enterprises. Hence, there is the positive relation between the debt service capacity and capital
structure of the firm.
10. Operating Leverage
The use of fixed cost in production process also affects the capital structure. The high operating
leverage; use of higher proportion of fixed cost in the total cost over a period of time; can magnify the
variability in future earnings. There is negative relation between operating leverage and debt level in
capital structure. Higher the operating leverage, the greater the chance of business failure and the
greater will be the weight of bankruptcy costs on enterprise financing decisions.
11.Stability In Cash Flow
The firm's cash flow stability also affects its capital structure. If firm's cash flows are relatively stable,
then it may find no difficulties in meeting its fixed charge obligation. As a result, the firm may attempt
to take the benefits by using leverage to some extent.
12. Nature Of Industry

24

Capital structure of a firm also depends on the nature of industry in which it operates. If there were no
barriers in industry for the entry of new competing firms, the profit margin of existing firms in the
industry would be adversely affected. As a result, the firm may find a more risky to use fixed charge
bearing securities.
13. Asset Structure
The sources of financing to be used are affected to several ways by the maturity structure of assets to
be used by the firm. If a firm has relatively longer term assets with assured demand of their products,
the firm attempts to use more long term debt. In contrast to this, the firms with relatively greater
investment in receivables and inventory rather than fixed assets rely heavily on short-term financing.
14. Lender's Attitude
Lender of any firm permits the use of debt financing only to a limited range. If management seeks to
use leverage beyond that permitted by industry norms, this may reduce the credit standing and credit
rating of the firm. As a result, lenders do not permit for additional debt financing.

Why is it so Important?
Any companys capital structure serves several key purposes.
First and foremost, its effectively an overview of all the claims that different players have on
the business. The debt owners hold these claims in the form of a lump sum of cash owed to
them (i.e., the principal) and accompanying interest payments. The equity owners hold these
claims in the form of access to a certain percentage of that firms future profit.
Secondly, it is heavily analyzed when determining how risky it is to invest in a business, and
therefore, how expensive the financing should be. Specifically, capital providers look at the
proportional weighting of different types of financing used to fund that companys
operations.
For example, a higher percentage of debt in the capital structure means increased fixed
obligations. More fixed obligations result in less operating buffer and greater risk. And
greater risk means higher financing costs to compensate lenders for that risk (e.g., 14%
interest rate vs. 11% interest rate).
Consequently, all else equal, getting additional funding for a business with a debt-heavy
capital structure is more expensive than getting that same funding for a business with an

25

equity-heavy capital structure.

Capital Structure and Risk-Return Tradeoff:

The capital structure of a firm should be designed in such a way that it keeps the total risk of
the firm to the minimum level. The financial or capital structure decision of a firm to use a
certain proportion of debt or otherwise in the capital mix involves two types of risks:
26

1.

Financial Risk: The financial risk arise on account of the use of debt or fixed interest
bearing securities in its capital. A company with no debt financing has no financial risk.
The extent of financial risk depends on the leverage of the firms capital structure. A firm
using debt in it capital has to pay fixed interest charges and the lack of ability to pay
fixed interest increases the risk of liquidation. The financial risk also implies the
variability of earning available to equity shareholders.

2.

Non-Employment of Debt Capital (NEDC) Risk: If a firm does not use debt in its
capital structure, it has to face the risk arising out of non-employment of debt capital.
The NEDC risk has an inverse relationship and vice versa. A firm that does not use debt
cannot make use of financial leverage to increase its earnings per share: it may also lose
control by issue or more and more equity; the cost of floatation of equity may also be
higher as compared to costs of raising debt.

Thus a firm has reach a balance (trade-off) between the financial risk and risk of nonemployment of debt capital to increase its market value.

The finance manager, in trying to achieve the optimal capital structure has to determine the
minimum overall total risk and maximize the possible return to achieve the objective of
higher market value of the firm.

Major Participants in Securitization Process:

27

Securitization is the process whereby relatively illiquid financial assets such as mortgages are
packaged together and sold off to individual investors. Securitization turns relatively illiquid
instruments into quite liquid investments called asset-backed securities. A market maker
agrees to create a secondary market by buying and selling the securities. Securitization
originated in the mortgage market in the early 1980s, when mortgage loans began to be
packaged together and sold off as securities in the secondary market often with government
insurance guaranteeing that the principal and interest would be repaid. Securitization became
popular because it provides a way of protecting against interest rate risk in an environment of
increased interest rate volatility. Securitization offers reduced credit risk because of the
pooling of assets.
The Concept of Securitization
Process of Securitization
Benefits of Securitization
The securitization process involves a number of participants. The role of major participants in
securitization process are given below.

1. Originator
The party behind a securitization is the originator. This entity generates (originates) or owns
the defined or identifiable cash flow (that is, an income stream from receivables). An example
of an originator with assets that can be securitized is a retail bank. Following assets are
typically securitized: mortgages, automobile loans, credit card receivables, trade receivables,
educational loans, etc. Securitized assets often have some or all of the following features: (i)
large pool that permits diversification; (ii) low default rate; (iii) insensitivity to interest rate
change; (iv) limited prepayment risk; (v) short maturity; and (vi) relatively homogeneous
pools.

2. Arranger
Originator usually appoints an arranger, which is typically a financial institution (e.g.
investment bank), to design and set up the securitization structure. An arranger: (i) determines
the structure of the risk profile of the receivables to create different tranches of security; (ii)
sets up a SPV; and (iii) designs credit enhancement and liquidity support

3. Special Purpose Vehicle (SPV)

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Setting up the SPV

The legal status of the SPV depends on the jurisdiction where it is established. In many
jurisdictions it is a thinly capitalized corporate entity (that is, a company that has a very low
equity capital compared to the amount of debt it owes) and someone other than the originator
holds SPVs shares, typically a trust. In other jurisdictions, such as those where the trust
concept is not recognized, there may be legislation governing securitization and the SPV may
be set up according to its provisions. Such legislation may provide, for example, that the SPV
can be established as a fund, without legal personality, mutually owned by investors, or as a
corporate entity with limited liability (e.g. limited liability company).
If a jurisdiction is unable to accommodate a required legal form for an SPV, or there are
certain advantages to establishing it elsewhere, then it will be established outside the
jurisdiction of the originator (offshore). Tax considerations are particularly important in
choosing where to establish the SPV and they are often established in low-tax or no-tax
jurisdictions, such as Ireland, Luxembourg, the Netherlands and the Cayman Islands.
The reasons the SPV is established in such ways are so that it: (i) s not treated as a subsidiary
of the originator; (ii) is not affected by the insolvency of the originator; and (iii) does not
need to have its balance sheet consolidated with the originators balance sheet (although this
may depend on the accountancy practices and various other rules in the jurisdiction).
Ensuring that SPV is bankruptcy remote
It is important that the SPV is, as far as legally possible, bankruptcy remote from the
originator (that is, the SPV is set up and operates so that it is highly unlikely that it will
become subject to bankruptcy proceedings initiated over the originator). Common steps to
achieve bankruptcy remoteness include: (i) placing restrictions in the SPVs charter and
transaction documents that prevent it from incurring liabilities outside those contemplated by
the securitization (ii) appointing directors (or a director) independent of the originator; (iii)
including limited recourse wording in all significant transaction documents that restricts a
counterparty taking enforcement action against the SPVs assets.
Issuing Securities
The newly incorporated SPV (also called the issuer) issues securities to investors to fund the
purchase of the isolated receivables from the originator. The securities are usually bonds or
notes or, occasionally, equity securities, and may be issued in several structured tranches (that

29

is, different classes of securities with different payment priorities and characteristics, such as
different credit ratings or interest rates.
The securities may be privately or publicly issued, depending on the individual circumstances
of a transaction. However, if publicly listed, various listing requirements must usually be
complied with when issuing the securities. A party separate from the investors usually holds
on behalf of all investors the benefit of the covenants and rights contained in the securities.
Where the trust concept is recognized, this rights holder is typically a trustee (e.g. in US) and
the securities are usually constituted under an indenture (public issuance) or bond purchase
agreement (private placement) that set out the terms and conditions of the issue and also the
rights in the securities held by the trustee.
Tranching the securities
To optimize the risk profile of the securities and therefore maximize the range of investors to
whom they can be sold, the securities are divided into different classes. These typically
consist of several sequential tranches with differing priorities as to payment of principal and
interest, and carrying differing rates of interest. The more senior tranches have the right to
priority of payment over more junior tranches, but the more junior tranches carry a higher
rate of interest. Each tranche (or at least the most senior tranches) is generally given a credit
rating by a credit rating agency. Securitization transactions usually involve such multipletranche structures. As the sophistication of structured products and the combination of
derivative and securitization structures increases (e.g. synthetic securitizations), it has
become possible for investors to specify credit, yield, maturity and currency characteristics
for arrangers to structure, rather than wait for issuers with the desired credit quality and
borrowing needs to issue appropriate securities.
Types of SPVs
The methods employed to transfer and take assets off-balance sheet involve direct sales using
SPVs or other conduits. There are three types of conduits: single-seller SPV, multi-seller
conduits, and securities arbitrage vehicles. The single-seller SPV purchases assets from a
single originator. Banks originating large uniform assets (mortgage debts) usually use these
instruments. Multi-seller conduits are legal entities administered and serviced by the banks to
provide funds either through direct loans or asset purchase agreements under which the SPV
purchases trade receivables. The originating bank normally provides direct credit
enhancements and provision of liquidity facility to the conduit. Securities arbitrage vehicles
30

are organized to buy rated securities that are funded through the structure of the program,
rather than by the underlying assets. That is, the conduit must be structured so as to ensure a
steady inflow of new assets or obligations. The assets (current or future receivables) are
transferred from an originating (sponsor) balance sheet to the balance sheet of an SPV

4. Investors
Typically, financial institutions, insurance companies, pension funds, hedge funds,
companies, high net worth individuals. Investors purchase the securities issued by the SPV
according to their risk/return preferences. Tranching offers investors the opportunity to
diversify their investment portfolio by purchasing securities with different seniority and yield.
Market liquidity of securities is also very important to investors, so that they do not have to
hold the security to maturity but can instead sell it on a public market.

5. Servicers
SPV appoints the servicer to administer and collect the underlying receivables in the capacity
of SPVs agent for a servicing fee stipulated under the servicing agreement. The originator or
a company within the originators group is often appointed as servicer (so that the profit from
securitization can be extracted from the SPV to the originator trough service agreement).
However, sometimes a third party servicer is appointed.

6. Rating Agencies
The SPV engages the rating agencies to rate the creditworthiness of the securities. Rating
agencies rate the securities to indicate whether the SPV has a strong or weak capacity to pay
interest and principal. The rating is provided after detailed statistical analysis on the
probability of default and the effects of such default on the ability of the SPV to comply with
its payment obligations in respect of the securities.
Rating agencies play a pivotal role in the securitization process as the ultimate appraiser of
the underlying pool of collateral. In their process of appraising and evaluating the likelihood
of default by subjecting the cash flows of the pool of underlying assets to stress tests under
severe market conditions, various risks are priced to determine the fair market value of the
new securities. Investors acceptance of the ratings as a well-defined standard, as well as the
appropriateness of the amount of credit enhancement, are paramount for a successful
securitization process for ABS, as they need not perform individual appraisals for the new
instruments that could be prohibitively costly. Assuming credit risk analysis is undertaken for
31

a rated security, the decision to invest turns into consideration of market or interest rate risk,
and analysis of duration and convexity of the underlying instrument.
There are three main credit rating agencies: (i) Standard & Poors; (ii) Moodys Investor
Services; and (iii) Fitch Ratings.

7. Enhancement Providers
Investors usually demand very high investment grades for asset-backed securities (ABS). The
assets themselves do not earn these grades without enhancements that reduce risks of credit,
liquidity, currency and prepayment.
Credit enhancement reduces the risk of default of the debtors on the underlying assets. Credit
enhancement is used to improve the liquidity, marketability, appeal, and safety of the
underlying cash flows (interest and principal) of a new instrument in the capital market. It is a
form of dressing up an illiquid asset by beefing up its pay-off, while reducing the variability
of cash flows so that wider classes of investors find the rate of return commensurate with
risk. The amount and type of credit enhancement depends on the extent to which one wishes
to make the new instrument in par to a highly-rated security. This enhancement is provided
internally by (i) underwriters or dealers that agree to buy the entire subordinated tranche or
(ii) banks or insurers that provide unconditional guarantees which the SPV can draw if
debtors default.
Liquidity enhancement reduces the risk of failure of the servicer to timely transfer debtors
payment to the SPV, which might ultimately prevent ABS investors from being paid.
Liquidity enhancement can also address the risks of set-off, prepayment, discounts and other
reductions of payment, as well as invalid assignments of underlying assets. This enhancement
is provided in the same manner as the credit enhancement.
Financial institutions specializing in swap transactions enter into swap contracts with the SPV
to take on risks of interest rates changes, currency movements or defaults and other nonpayment events with respect to underlying assets (effectively providing insurance to SPV
against these risks).

8. Regulators
Many jurisdictions have now legislated to make securitization possible or to promote their
securitization market. Regulatory issues that may arise (whether as part of securitization
legislation or otherwise) include: (i) issues affecting the originator, such as accountancy
32

practices and capital adequacy requirements; (ii) the structuring of the SPV; (iii) whether any
of the parties must be licensed or are subject to supervision by a regulatory body; (iv) the
rules on offering and trading securities; (v) laws governing the underlying receivables (e.g.
consumer lending obligations); (vi) data protection restrictions impacting on the proposed

33

transfer of customer information accompanying the transfer of receivables.

34

ADVANTAGES AND DISADVANTAGES OF CAPITAL

STRUCTURE DECISION:
Companies often use debt when constructing their capital structure, which helps lower total
financing cost. In addition to the relatively lower cost of debt financing, using debt has other
advantages compared to equity financing, despite potential issues that using debt may cause,
such as ongoing financial liabilities and potential bankruptcy risk. In general, using debt
helps keep profits within a company and increases returns on equity for current company
owners and helps secure tax savings.

Cost Reduction
Compared to equity, debt requires lower financing cost. Thus, companies often mix debt into
their capital structure to bring down the average financing cost. Using debt, companies are
contractually liable to make periodic interest payments and return debt principal at maturity.
As a result, debt holders bear less risk, compared to equity holders, who often have no
recourse for their investments if companies fail. In the event of a company liquidation, debt
holders also have the senior claiming rights to company assets, which gives them another
layer of protection for their investments. Therefore, a safer debt investment requires less cost
compensation.

Profit Retention
While using debt may add pressure to a companys ongoing operations as a result of having
to meet interest-payment obligations, it helps retain more profits within the company
compared to using equity, which requires the sharing of company profits with equity holders.
Using debt, companies need to pay only the amount of interest out of their profits. Using
equity, on the other hand, the more profits a company makes, the more it has to share with
equity investors. To take advantage of such a debt-financing feature, companies often use
debt to finance stable business operations in which they can more easily make ongoing
interest payments and, meanwhile, retain the rest of the profits to themselves.

Financial Leverage
Using debt is also advantageous to existing owners because of the effect of financial leverage.
When companies use debt to provide addition capital for their business operations, equity
owners get to keep any extra profits generated by the debt capital, after any interest
35

payments. Given the same amount of equity investments, equity investors have a higher
return on equity because of the additional profits provided by the debt capital. As long as
using debt doesnt threaten the financial soundness of a company in times of difficulties,
equity owners welcome certain debt uses to help enhance their investment returns.

Tax Savings
Using debt helps lower a companys taxes because of allowable interest deductions. Tax rules
permit interest payments as expense deductions against revenues to arrive at taxable income.
The lower the taxable income, the less taxes a company pays. On the other hand, dividends
paid to equity holders are not tax-deductible and must come from after-tax income.
Therefore, tax savings help further reduce a companys debt financing cost, which is an
advantage that equity financing lacks.

Amplifies Return-on-Equity
Return on equity, or ROE, is commonly used as a measure of business performance. It is the
product of earnings, asset turnover and financial leverage or debt. The more leverage or debt
you have in your capital structure, the more it amplifies your potential earnings. At the same
time, an increase in debt or leverage also reduces earnings since interest is paid out of net
earnings.

Greater Control and Flexibility

Debt financing allows you to keep full ownership over your business. With full ownership
comes complete control. Equity financing is an investment in the ownership rights of the
company. That is, equity investors get a portion of earnings. If there are no earnings, equity
investors aren't paid. However, debt investors must be paid no matter what happens. Failure
to pay interest can result in a default, which results in a credit event. In this way, capital
structure helps to better control and manage operational flexibility.

Framework for Negotiation

Capital structure provides an organized way to raise capital. Both debt and equity have their
advantages and disadvantages. The equity investor gets a portion of your earnings no matter
how much earnings grow, and the amount earned by equity investors is not limited by a
36

certain period of time like debt. Once the loan is paid off, the creditor has no right to your
earnings. Debt financing is also easier to negotiate and handle administratively than equity,
which can come with complex reporting requirements.

Equity Advantages
Capital structure also provides flexibility in raising funds. One advantage to equity financing
for small business is that it is generally more available than debt financing. If your business is
unproven, lenders have nothing to base future cash flows on. This may result in a requirement
for a personal guarantee from one of the business owners. Equity financing is not required to
be paid back immediately.

Investor Expectations
Neither profits nor business growth nor dividends are guaranteed for equity investors. The
returns to equity investors are more uncertain than returns earned by debt holders. As a result,
equity investors anticipate a higher return on their investment than that received by lenders.

Disadvantage:
Business Form Requirements
Legal restrictions govern the use of equity financing and the structure of the financing
transactions. In fact, equity investors have financial rights, including a claim to distributed
dividends and proceeds from the sale of the company in which they invest. The equity
investors also have governance rights pertaining to the board of directors election and
approval of major business decisions. These rights dilute the ownership and control of a
company and increase the oversight of management decisions.

Financial Returns Distribution

Each investor in a company has a right to the cash flow generated by the business after all
other claims are paid. If the business is sold, the owners share cash equal to the net proceeds
of the business if a gain occurs on the sale. The investors net return is equal to the net
proceeds of the sale less the cash they invested in the business. The legal restrictions that
govern the use of equity financing determine the return received by an individual investor.

37

Disadvantages of Debt Financing:

The main disadvantage of debt financing is that it requires a small business to make regular
monthly payments of principal and interest. Very young companies often experience
shortages in cash flow that may make such regular payments difficult, and most lenders
provide severe penalties for late or missed payments. Another disadvantage associated with
debt financing is that its availability is often limited to established businesses. Since lenders
primarily seek security for their funds, it can be difficult for unproven businesses to obtain
loans without a personal guarantee from one of the principals in the business.

Disadvantages of Equity Financing:

The main disadvantage of equity financing is that the founders must give up some control of
the business. If investors have different ideas about the company's strategic direction or daytoday operations, they can pose problems for the entrepreneur. In addition, some sales of
equity, such as initial public offerings, can be very complex and expensive to administer.
Such equity financing may require complicated legal filings and a great deal of paperwork to
comply with various regulations. For many small businesses, therefore, equity financing may
necessitate enlisting the help of attorneys and accountants.
Unlike equity, debt must at some point be repaid. Interest is a fixed cost which raises the
company's break-even point. High interest costs during difficult financial periods can increase
the risk of insolvency. Companies that are too highly leveraged (that have large amounts of
debt as compared to equity) often find it difficult to grow because of the high cost of
servicing the debt.
Cash flow is required for both principal and interest payments and must be budgeted for.
Most loans are not repayable in varying amounts over time based on the business cycles of
the company. Debt instruments often contain restrictions on the company's activities,
preventing management from pursuing alternative financing options and non-core business
opportunities. The larger a company's debt-equity ratio, the more risky the company is
considered by lenders and investors. Accordingly, a business is limited as to the amount of
debt it can carry.
The company is usually required to pledge assets of the company to the lender as collateral,
and owners of the company are in some cases required to personally guarantee repayment of
the loan.
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Capital Structure of Internet Companies: Case Study

ABSTRACT
We analyze the financing decisions and capital structure of internet companies and relate
observed findings to the common capital structure theories. Large internet companies usually
have low debt and small internet companies have high debt. We find that the trade-off theory
of capital structure, pecking order theory, market timing theory and other theories cannot
individually explain a firms capital structure. However, they can compliment each other in
describing some patterns of observed behavior. We also suggest a number of
recommendations for capital structure theory and practice.
Introduction
The modern theory of capital structure began with the famous proposition of Modigliani and
Miller (1958) that described the conditions of capital structure irrelevance. Since then, many
theories of capital structure have been developed including trade off theory, pecking order
theory, agency cost theory, life cycle theory and flexibility theory. After so many innovations,
capital structure remains one of the most controversial and debatable issue in corporate
finance.
The key issues are as follows. First, an immense gap exists between theories and practice.
Graham and Harvey (2001) found that less than 50% of theoretical ideas find some support
among managers. Second, there are big differences in the researchers opinion. For example,
Chirinko and Singha (2000), Leary and Roberts (2010) and Frank and Goyal (2003) claim
that trade-off theory drives capital structure decisions while Shyam-Sunder and Myers (1999)
and Lemmon and Zender (2008) claim that pecking-order theory drives capital structure.
Third, there is difference among opinions about the direction that future work on capital
structure should take. For instance, Harris and Raviv (1991) argue that asymmetric
information theories of capital structure are not promising. However, the stream of research
related to asymmetric information has not stopped since then. Furthermore, the financial
crisis during 2008 and 2009 showed that corporate managers appeared to lack an
understanding of the role of asymmetric information. The market for mortgage-backed
securities, which many believe was at the core of financial crisis, involved asymmetric
information between investors and issuers. Various scandals, such as the one involving Bernie
Madoff, illustrate the depth of asymmetric information problems between firms insiders and
investors.
39

The present paper attempts to analyze issues described above. We look at current practices of
internet companies and compare them to existing theories. We analyze the current practice of
71 companies including 29 large companies and 42 small companies. The size of the
companies is from 40 million to 223.48 billion. With the help of spreadsheet analysis we first
find an optimal capital structure for a given company. Spreadsheet analysis is mostly based
on the trade-off between tax advantages of debt and increasing risk from debt financing. This
analysis implies that large companies in the Internet industry are underleveraged. For
example, for Google Inc., the optimal debt ratio is 16.2% and the current debt ratio is just
8.8%. We also find that most small companies in the Internet industry are overleveraged. For
example, the optimal debt ratio for Ediets.Com Inc is 0%, but the current debt ratio is as high
as 59.54%.
We then describe other factors that have not been taken into consideration in the spreadsheet
analysis, which affect managers decisions on companys capital structure. We find that no
single theory of capital structure can explain the observed patterns of capital structure in
internet industry. The trade-off theory of capital structure is unable to accurately explain why
only a small fraction of firms that are increasingly profitable utilize debt as a source of
financing. Spreadsheet analysis shows that firms current capital structures are distant from
their optimal. Also we find that the pecking order theorys prioritization of sources of
financing is only maintained in certain situations. For example, we see that younger firms and
firms who undergo high-growth periods with net losses do not utilize debt before equity
financing. Most companies issued equity through an initial public offering before utilizing
debt which opposes what is expected from the pecking order theory.
The market timing theory pays tribute to some actions taken by nearly every firm in our
sample. For example, nearly all companies issue equity through public offerings at opportune
times, most notably during the tech craze or dot.com bubble of the late 1990s. We also
see firms undergo public offerings when the market has recovered from the tech crash of
2000 or at other times when management feels their stock is overvalued. We see companies
make stock repurchases at windows of opportunities where they believe their stock is
undervalued. However, from a broader point of view, the market timing theory is limited in
explaining firms capital structure besides IPO decision.
Flexibility is largely unexplored area of capital structure that can explain many patterns of
capital structure for internet industries. Both equity and debt holders do place value on
flexibility, especially in the recent years of turmoil in capital markets.
40

Internet companies seem to put an especial emphasis on flexibility when managing their
capital structures given the innovative nature of their industry.
There is a home bias in capital structure for most companies in our sample.
Internet companies can use international financing more efficiently. Some reasons for that
include the availability of lower interest rates, flexible regulation for dynamic companies, no
capitalization restrictions, reducing interest rate risk by using flexible interest rates in markets
which have low correlation between each other, using modern financing arrangements like
international project financing or non-recourse debt to mitigate agency problems.
Small internet companies should have less debt. Using a lot of debt by small companies is
inconsistent with almost any existing theory of capital structure.
Credit rating concerns are unexplored area of capital structure theory. The capital structure
management of large internet companies is strongly consistent with the view that managers
are deeply concerned about ratings.
With regard to existing theories our analysis revealed that any single theory has major
problems in explaining capital structure management of internet companies. It suggests that a
unified approach should be developed in near future. Also we disagree with Harris and Raviv
(1991) that asymmetric information theories are less promising.
We find that asymmetric information is important in explaining many patterns of capital
structure behavior of internet companies but managers do not have a practical tool to use it
more efficiently. At the same time given that the gap between theory and practice is very
large, we agree with Harris and Raviv (1991) in that the door is still widely open for new
theory of capital structure which can be helpful to make a bridge between theory and practice
of capital structure.
The rest of this paper is organized as follows. Section 2 describes internet industry. Section 3
presents a review of capital structure theories. Section 4 describes in details the analytical
method used in the paper and the spreadsheet used to analyze firms capital structure. Section
5 provides detailed examples of some firms capital structure analysis. Section 6 presents the
results of firms capital structure analysis and the conclusion is drawn in Section 7.

The internet industry

The internet started out as an American military project in the 1950-60s and has evolved into
a modern mainstream phenomenon. It is used by common businesses for marketing and sales,
for searching and sharing of files (including documents, audio and video files) by businesses
and households, and it is even used to facilitate online communities with forums and
blogging with popular websites such as Facebook, Twitter and Youtube. The Internet has
41

revolutionized the computer and communications world like nothing before. The Internet is at
once a world-wide broadcasting capability, a mechanism for information dissemination, and a
medium for collaboration and interaction between individuals and their computers without
regard for geographic location. The Internet represents one of the most successful examples
of the benefits of sustained investment and commitment to research and development of
information infrastructure. Beginning with the early research in packet switching, the
government, industry and academia have been partners in evolving and deploying this
exciting new technology.
In the technology industry, one kind of the companies is pretty famous which is called
information provider companies. It may sound unfamiliar for most people. However, most
people are familiar with Internet search engine companies like worldwide Google, Yahoo,
Baidu and so on. Many people probably depend on these internet search engine companies
when they use internet to search. These internet search engine companies are also called
information provider companies which provide different information to various customers.
For instance, the famous search engine company Google can provide a tool to help customers
to acquire wanted information. However, different information providers can provide
different types of information. Like Youku, a video sharing website, can provide all types of
videos information. With the development of the industry, new information provider
companies like Facebook and LinkedIn can help people to establish connection and share
information with others. In the information provider industry, companies provide information
in different ways, but the basic concept is to provide the needed information to customers.
In the Internet industry, the leader companies and the laggards have the big difference in
Market Cap, long term debt to equity, P/E, net profit margin and other aspects. For instance,
the leader companies, Google, Yahoo and Baidu, have the market cap of $272.1B, $321.9B
and $380.4B. On the contrary, some small companies like, VRX Worldwide, Inc, Armada
Data Corp, Alphinat Inc. have relatively small market cap of $1.0 M, $1.8M and $1.9M. P/E
is also very different among different companies. For instance, Facebook that held its initial
public offering (IPO) on May 18, 2012, has a P/E of 1805.33. Google has its P/E ratio of
25.62. Most of the big companies have high net profit margin. For instance, Google has the
net profit margin of 20%, and Yahoo has the similar net profit margin of 20.23%.
Compared to Google and Yahoo, Baidu has the highest net profit margin of 44.12%.
Small companies have the various net profit margin some companies have relatively high net
profit margin. Atrinsic, Inc. has a market cap of $0.13M and has a net profit margin of

42

36.7%. eMedia Networks also has a relatively small market cap of $0.4M. However, it has a
quite different net profit margin of 11.59 compared with Atrinsic, Inc -36.7%.
Capital structure theories
This section describes capital structure theories. We also discuss some challenges faced by
each theory that provides a basic for further discussions about existing practices in capital
structure theory and management.
Trade-off theory
In contrast to dividends, interest paid on debt reduces the firms taxable income. Debt also
increases the probability of bankruptcy. Trade-off theory suggests that capital structure
reflects a trade-off between the tax benefits of debt and the expected costs of bankruptcy
(Kraus and Litzenberger, 1973). Miglo (2010) suggests a model where optimal debt level is
given by the following:
D=TR
T+K

(1)

Here R stands for maximal earnings, T is corporate tax rate and k measures bankruptcy costs.
If k is higher in (1), the equilibrium level of D should be lower. As the expected bankruptcy
costs increase, the advantages of using equity also increase. This result has several
interpretations. Large firms should have more debt because they are more diversified and
have lower default risk. Tangible assets suffer a smaller loss of value when firms go into
distress. Hence, firms with more tangible assets should have higher leverage compared to
those that have more intangible assets, such as research firms. Growth firms tend to lose more
of their value than non-growth firms when they go into distress. Thus, theory predicts a
negative relationship between leverage and growth.
When T increases in Equation 1, debt should also increase because higher taxes lead to a
greater tax advantage of using debt. Hence, firms with higher tax rates should have higher
debt ratios compared to firms with lower tax rates. Inversely, firms that have substantial nondebt tax shields such as depreciation should be less likely to use debt than firms that do not
have these tax shields. If tax rates increase over time, debt ratios should also increase. Debt
ratios in countries where debt has a much larger tax benefit should be higher than debt ratios
in countries whose debt has a lower tax benefit.
As suggested in (1), if R increases, D should also increase. Thus, more profitable firms
should have more debt. Expected bankruptcy costs are lower and interest tax shields are more
valuable for profitable firms.

43

Although trade-off theory predicts that the marginal tax benefit of debt should be equal to the
marginal expected bankruptcy cost, the empirical evidence is mixed. Some researchers argue
that the former is greater than the latter because direct bankruptcy costs are small and the
level of debt is below optimal (Graham, 2000). Others find that indirect bankruptcy costs can
total as much as 25 percent to 30 percent of assets value and are thus comparable with tax
benefits of debt (Molina, 2005; Almeida and Philippon, 2007). Additionally, including
personal taxation in the basic model can reduce the tax advantage of debt (Green and
Hollifield, 2003; Gordon and Lee, 2007) because tax rates on the return from equity such as
dividends or capital gain are often reduced.
Trade-off theory of capital structure is a foundation of spreadsheet analysis described in
Section 4. The spreadsheet analysis takes into account taxes and also increasing risk from
debt financing.

Other theories of capital structure

Pecking-order theory.
The key element of pecking-order theory is asymmetric information between firms insiders
and outsiders. Information asymmetries exist in almost every facet of corporate finance and
complicate managers ability to maximize firm values. Managers of good quality firms face
the challenge of directly convincing investors about the true quality of their firm especially if
this concerns future performance. As a result, investors try to incorporate indirect evidence in
their valuation of firm performance by analyzing information-revealing actions including
capital structure choice.
Myers and Majluf (1984) set forth pecking order theory. Equity is dominated by internal
funds in pecking order theory. Low-quality firms use equity as much as internal funds but
high-quality firms prefer internal funds because shares issued by the company can only be
sold with discount (i.e. below their true value) because of imperfect information problems.
Similarly debt dominates equity. Debt suffers from miss valuation less than equity. The same
holds if the firm has available assets-in-place. Hence a pecking order emerges: internal
funds, debt, and equity (Myers and Majluf, 1984).
Good-quality firms tend to use internal funds for financing as much as possible. Because
low-quality firms do not have as much profits and retained earnings as high-quality firms,

44

they use external sources, usually debt, more frequently. This helps to explain the described
above puzzle about the negative correlation between debt and profitability.
Also pecking order theory predicts that a higher extent of asymmetric information reduces
the incentive to issue equity.
Signaling
In the pecking order model, good quality firms have to use internal funds to avoid adverse
selection problems and losing value. These firms cannot signal their quality by changing their
capital structure. In signaling theory capital structure serves as a signal of private information
(Ross, 1977). If a separating equilibrium exists, high-quality firms issue debt and low-quality
firms issue equity. The empirical prediction is that firm value (or profitability) and the debtto-equity ratio is positively related. The evidence, however, is ambiguous. Most empirical
studies report a negative relationship between leverage and profitability as discussed earlier.
In a similar spirit, some studies document the superior absolute performance of equity-issuing
firms before and immediately after the issue (Jain and Kini, 1994; Loughran and Ritter,
1997). Several studies examine long-term firm performance following capital structure
changes. Shah (1994) reports that business risk falls after leverage-increasing exchange offers
but rises after leverage-decreasing exchange offers. Jain and Kini (1994), Mikkelson, Partch,
and Shah (1997), and Loughran and Ritter (1997) document the long-run operating
underperformance of equity issuing firms compared to non-issuing firms.
Agency cost-based theories of capital structure
Agency costs arise because managers do not necessarily act in the best interests of
shareholders who also may not act in the best interests of creditors. Including agency costs in
the basic model can help to explain some problems of trade-off theory discussed above such
as debt conservatism.
If an investment yields large returns, equity holders capture most of the gains. If, however,
the investment fails, debt holders bear the consequences. As a result, equity holders may
benefit from investing in highly risky projects, even if the projects are value decreasing.
Jensen and Meckling (1976) call this the asset substitution effect. Debt holders can
correctly anticipate equity holders future behavior. This leads to a decrease in the value of
debt and reduces the incentive to issue debt. Myers (1977) observes that when firms are likely
to go bankrupt in the near future, equity holders may have no incentive to contribute new
capital to invest in value-increasing projects. Equity holders bear the entire cost of the
45

investment, but the returns from the investment may be captured mainly by the debt holders
(debt overhang).
On the other hand, some agency theories favor higher debt. For example, Jensen (1986)
argues that debt improves the discipline of an entrenched manager (so called debt and
discipline theory).
Flexibility theory of capital structure and life cycle theory of capital structure.
Firms in the development stage have little favorable track record (i.e., credit ratings) of
borrowing (Diamond, 1991) and are most likely to be turned down for credit when they need
it the most. Thus, firms in the development stage that have little financial flexibility will
abstain from issuing risky debt and will instead issue equity. Firms in the maturity stage begin
generating positive earnings and have more financial flexibility than developing firms.
Accordingly, these firms rely more on debt financing to fund their investments as they face
less financing constraints and as they expect to repay their debt with growing future earnings.
Flexibility theory finds some support in empirical studies (Byoun, 2008) and managers
surveys (Graham and Harvey, 2001). This theory helps to explain why small and risky firms
issue equity and why these firms do not follow pecking-order theory. Gamba and Triantis
(2008) develop a theoretical model that analyzes optimal capital structure policy for a firm
that values flexibility in the presence of personal taxes and transaction costs. The importance
of financial flexibility as compared to major theories of capital structure remains an open
question. More work that compares flexibility theory with other theories is expected. Also it
was noted that many young firms especially venture firms do not issue common equity but
rather convertible preferred equity which resembles debt more than equity.
Life cycle theory of capital structure argues that besides financial flexibility there are other
factors which can explain financing patterns of firms in different stages of their development
(Damodaran, 2003). Start-up firms do not have much profit, so the tax advantage of debt is
not as important as for a mature firm. The start-up firms do not require incentives for
managers since there is no large separation between ownership and management like in the
case of big public corporations. This leads to the idea that mature firms value debt more
compared to start-up firms. To what extent the life cycle theory represents a separate theory
of capital structure rather than a combination of arguments from other theories remains an
open question.

46

Method of research.
The choice of case study approach is motivated by the following. First, there are a number of
researchers calling for more case studies in capital structure management (Graham and
Harvey, 2001). Second, case study is an effective way of research in areas which include
several layers of analysis and different approaches and theories. Section 3 suggests that
capital structure management represents such an area. There is a lot of competing theories of
capital structure. Furthermore one of our main objectives is to find firms optimal capital
structure policies (as opposite to existing policies). Some of the theories are better
formalized and make it more simple for managers to use in real life situations (such as tradeoff theory) while others are far from that (such as asymmetric information). The case study is
simply the best research strategy because the problem under study is to reach understanding
in a complex context (Singleton, Straits, and Straits (1993), Mertens (1998)). Campbell
(1989) advocates a case study design for investigating real-life events, including
organizational and managerial processes. Third, available sample for capital structure
management analysis of large companies is small so our sample covers a good fraction of
firms.
We analyze companies capital structure using the following questions (see Miglo (2010) for
more details).
1. What is the firms current debt/equity ratio?
2. Is the firms debt/equity ratio low or high compared with other firms at the same industry
or related industries?
3. Is the firms current debt/equity ratio explained by the firms financial policy or by the
current market conditions?
4. What is the firms optimal capital structure according to WACC (weighted average cost of
capital) approach?
5. If current debt/equity ratio different from optimal, then what factors, which are not taken
into consideration in the spreadsheet analysis may explain this difference?
When working on above questions we use spreadsheet analysis along with capital structure
theories. These theories are Pecking-Order Theory, Trade-Off Theory, Agency Cost,
Flexibility and some others described in previous chapter.

47

Questions 1, 2 and 4 deal with financial calculations. By doing so, we can find out the
companys Debt/Equity Ratio and its WACC. WACC is the expected return on all of a
companys securities. It is calculated by multiplying the cost of each capital component by its
proportional weight and then summing:
WACC= (E/V)rE+ (D/V)rD(1-TC)
Here D and E are the market value of the firms debt and equity, V=D+E is the firms total
market value, rD and rE are the cost of debt and equity, and TC is the marginal corporate tax
rate. We take tax into consideration, since interest paid on a firms borrowing can be
deducted from taxable income, which is the so called tax benefit.
To get the optimal capital structure, we change D/(D+E) ratio from 0% to 100% as
hypotheses, and calculate several financial parameters for different ratios. Then we find one
that has minimal WACC and respectively maximal market value for the firm.
More specifically, we first calculate :
=[1+(1- TC)D/E] 04
Then, we calculate rE and rD by the following equations:
rE=Current Short Term Government Rate + Risk Premium
rD=Risk-Free Interest + Default Premium5
Then, we calculate the WACC based on the equation above, list all the WACC for different D/
(D+E) ratios, and finally find the minimum WACC from the list which corresponds to the
optimal capital structure.
With regard to question 3, we usually look at the firms debt/equity ratio over the last few
years. We find for example, that the Oracles D/E ratio was growing from 2005 to 2008. With
a further study, we believe a part of the reason for the growing D/E ratio is Oracles financial
policy, when the company aggressively purchased several competitors during that period and
accumulated a large amount of debt.
As to question 5, we find that the optimal debt/equity ratio (based on spreadsheet analysis) of
eBays is significantly higher than its current ratio. We suggest that this happened because
high bankruptcy cost of the industry and the needs for flexibility for future financing are not
taken into consideration in the WACC approach. We hold the view that eBay invested so
much money, time and effort to develop specific products, that the consequence can be very
48

serious if it fails due to a large amount of debt. The primary reason is the companys large
proportion of intellectual property which cannot be quickly converted to cash in a financial
distress situation. Moreover, the e-commerce industry is still in its growth stage, the future
financing requirements of the industry are unknown, therefore issuing stocks to finance
todays capital needs leaves firms with more flexibility for future financing than borrowing
money.
We also find that the agency cost for Microsoft is relatively low, and we explain this
phenomenon by pointing out that the biggest shareholder of Microsoft Bill Gates has been
deeply involved in companys management. When there are fewer conflicts between
managers and shareholders, there would be less agency cost.
We use an excel file that is divided into following parts6 : Inputs, Operating lease
information, Debt, Tax rate, and Calculations. Inputs part has three components, financial
information, market information, and general market data. Financial information includes
earnings before interest, taxes and depreciation (EBITDA) and depreciation and amortization.
Market information includes number of shares outstanding, market price per share, Beta of
the company. Current long-term government bond rate, short-term interest rate, risk premium,
and country default spread are in the general market data.
Operating lease expenses are really financial expenses, and should be treated as such.
Accounting standards allow them to be treated as operating expenses. In this part, we convert
commitments to make operating leases into debt and adjust the operating income accordingly,
by adding back the imputed interest expense on this debt.
In the debt part, we find each companys book value and market value of debt. In each kind
of value, we find companies bank medium-term debt, bank long-term debt, bonds, unsecured
debentures and notes, senior debt securities, senior medium-term notes, subordinated
medium-term notes, and other notes. Then, based on firms income statement, we find their
earnings before tax and provision for taxes in the recent three years. Then we calculate their
average tax rate in three years.
The calculation part includes the following parts:
1. Input data;
2. Interest coverage ratios, rating of debt, default spreads, interest rates and probabilities of
default.

49

3. Current situation;
4. Capital structure and cost of capital calculation;
5. Main results.
We find most data about the company (earnings, expenditures, depreciation etc.) from yahoo
finance and edumarketinsight website (educational version of Standard and Poors data base)
for which we had passwords provided together with textbooks (usually it was Principles of
corporate finance by Brealey and Myers). Default spreads, risk premiums and other
information for point 2 could be found on bondsonline website or on Federal Reserve
website. Points 3-5 represent calculations.
We calculate D/(D+E) ratio, Beta of the firm, cost of equity, cost of debt, WACC, market
value of firm, and market price/share.

Examples of company capital structure analysis

We divide all companies into two groups, the large companies and the small companies. The
large companies are market cap larger than 1 billion dollars (for example Google and Yahoo),
and the small companies are market cap smaller than 1 billion dollars (for example Move and
Look Smart). This section presents the analysis of these companies. The following tables
show calculation results.

Google
Table 1. Results from Google Analysis 2013
Current Capital
Structure

Optimal Capital
Structure

Change

D/(D+E) Ratio
4.02%
10.01%
5.99%
Beta for the Stock
1.03
1.07
0.04
Cost of Equity
10.06%
10.51%
0.45%
Cost of Debt
2.47%
2.47%
0.00%
WACC
9.76%
9.70%
-0.06%
Firm Value (mln.)
273458
274988
1,530
Value/share
797
801
4.00
Google is a success story. Googles mission is to organize the worlds information and make
it universally accessible and useful for generations to come. Google has a vision of expanding
their resources while keeping its edge in the market. The acquisitions of related newborns and
continuous launches of diverse and unique products indicate its push for growth and
profitability while utilizing all the available resources possible. Google started its journey
50

back in 1995 with having a garage office and ended up announcing Initial Public Offering of
19,605,052 shares of Class A common stock that took place on Wall Street on August 18,
2004 which was highly awaited decision for public and as a result, the companys liquidity
increased. On December 31, 2004, Google had $2,132.3 million of cash, cash equivalents and
marketable securities, compared to $334.7 million and $146.3 million at the year-ends of
2003 and 2002 respectively. Since this time Google has mainly held on to these additional
cash flows holding over $3.5 billion in cash and cash equivalents in 2005 and 2006 to the
date when Google shares jumped to an all-time high above $1,000 after the search engine
giant reported a surge in mobile and video advertising that helped drive quarterly revenue up
23 percent in 2013.
Capital structure
Google uses more equity financing rather than debt financing as it evolved from introductory
to growing stage over the years. Google changed its debt/assets ratio from 4.7% to 8.4%
during 2010 and 2012 and now back to the 4.02% in 2013. Googles cash flow and profit are
so strong that they can finance the business with retained earnings.
Trade off theory states that the capital structure is the result of a trade-off between the tax
advantage of debt and higher risk and bankruptcy costs resulting from debt financing.
Spreadsheet analysis suggests that Googles optimal debt ratio is 10.01%, however, its current
debt ratio is 4.02%.
The pecking order theory implies that the company should use internal funds before using
debt and equity and should use external debt before external equity. Google uses internal
funds and equity but not debt which means Google considered going for IPO before debt
which contradicts the pecking order theory. Second, this theory implies 17 negative
correlation between debt and profitability which is true as Google is making profit although
not using a lot of debt. At the time of IPO, Google had enough profits to keep its operation
running but still, rather taking more debt, Google decided to gather funds through equity. The
reasons for Google to go public were these in accordance with Letter from the Founders,
published in 2010. It follows from that document that Google could restructure to get back
below 500 shareholders (meaning, essentially, find a way to buy back shares from our
employees) or it could continue to be a private company but at the same time live with having
to report its financial results like any public company or it could go public. The latter will
help to create a market for firm shares including shares belonging to employees.
51

On one hand, the agency cost theory favours low debt implying low bankruptcy cost and high
level of confidence for investors. This is consistent with Googles policies. On the other hand,
the agency cost theory states higher debt is good for a company because it can stimulate
manager to perform better. This part is not consistent with Google case. In Googles case, the
conflict between shareholders and managers has low importance as the company is very
profitable. In the long term the things may change. An important indicator of potential
conflict between shareholders and managers is the fraction of shares owned by managers. In
Google case it is 4% (see Table 2) that is much smaller than for example in Microsoft case. At
the same the total number of shareholders is quite large. We believe that Google use partial
ownership in terms of involvement of employees in shareholdings as a tool to motivate
personnel to perform efficiently instead of external pressure by creditors. Although by issuing
shares Google might be sharing ownership with different groups of people, but it is avoiding
the risk to let go companys control in few hands. The conflict between creditors and
shareholders is not likely to happen because Google has less concern for creditors issue as it
has less debt. According to the Google policy, the board of directors has an obligation to
Monitor and Manage Potential Conflicts of Interest. The Board will also ensure that there is
no abuse of corporate assets or unlawful related party transactions. One of the reasons why
Google wanted to go public rather than using debt could be to have fewer conflicts between
company and outsiders.
Table 2. Information about Google.
Equity
Market Cap (Mln.)
# of Institution Owners
# of Institution Owners
% Owned by Institutions
% Owned by Funds
% Owned by Insiders

GOOG
285,019
2,800
4,574
72.63
38.47
0.04

As the flexibility theory and life cycle theory propose it is not beneficial for new firms to use
debt financing, they rely more on equity to make their operations smooth at early stage of
their existence so they are considered more flexible. Google expansion and growth business
approach requires a lot of funds. Google historically pays cash for acquisition and expansion
(except YouTube deal). The initial public offering in August of 2004 raised $1,161.1M to help
the company growth. The performance of Google while using equity as core source of
52

financing became better since 2004. In 2004 Google has 170, 601 shares valued at $34M and
in 2005, Google acquired nine companies and all of the assets of another six other companies
for a total amount of $130.5M of cash. Google continued with the acquisition of YouTube in
2008, AdMob in 2010, Zagat in 2011, Motorola Mobility in 2012 and Waze in 2013.
According to life cycle theory for growing and mature firms it is more likely to have higher
leverage ratio which would result in low flexibility. It is opposite in Googles case as it does
not use a lot of debt. The Debt/equity ratio for Google in 2004 was higher than in 2013.
The signalling theory states that from the investors perspective, the market reaction on
issuance of debt is neutral and of equity is negative. In Googles case, the issuance of shares
at different stages made it successful and profitable so its a different outcome of the
signalling theory. http://www.linkedin.com/today/post/article/20130913153717-7298-whengoogle-went-public

Yahoo! Inc.
Table 3. Results from Yahoo Analysis 2013
D/(D+E)

Cost of
Equity

Cost of
Debt

WACC %

Ratio

Beta for
the
Stock

Market Value
of
Firm

Current
capital
structure

6.30%

0.92

8.33%

1.04%

7.87

3936905997

Optimal
capital
structure

25.00%

Change

18.70%

6
1.07

9.41%

2.14%

7.59

4081419460
2

0.15

1.08%

1.10%

0.28

1445134,626

Yahoo first appeared online in 1994 while the companys founders, David Filo and Jerry
Yang, were still students at university. The Company was later incorporated in March 1995
and completed its initial public offering on April 12 1996. Yahoo is the second largest firm in
the internet information providers industry and is the main rival of the industry leader
Google. Yahoo currently is a highly profitable and established company.
The big internet companies like Yahoo started life conservatively, preferring to avoid debt
and use the enormous amount of free cash flow that their businesses throw off every year to
grow their businesses.
53

1. Is Yahoos current debt/equity ratio high or low?

Yahoo! Inc.s debt/equity ratio is low. Yahoo! Inc. currently has a debt/equity ratio of 6.3%
and their optimal ratio is around 25%. Google has a debt/equity ratio of 4.02% and Microsoft
has 20.24%.
2. Is Yahoos current debt/equity ratio explained by the firms financial policy or by the
current market conditions?
Yahoos debt/equity is affected by both their policy and market conditions. Between 20042010 Yahoos debt/equity ratio was relatively stable though economic conditions were
significantly changing. This suggests that Yahoos debt/equity ratio is 20 affected by its
financial policy. The last time Yahoo! Inc. had a significantly higher debt/equity ratio was in
2003-2004. Around that time internet companies were recovering from the dot-com bubble
bursting. So it is reasonable for a company to have a shortage of funds and to use debt to stay
afloat. We also know that Yahoo! Inc. was competing heavily with Google at that time and
acquired a few companies in order to improve their services. Also as the economy was
recovering from 2010 onward the debt/equity ratio has had a slight downward trend. This
suggests that debt/equity ratio is also affected by market conditions. As the economy
improves, companies earnings typically increase and debt/equity ratio decreases.
3. Optimal capital structure analysis.
As was mentioned above Yahoo! Inc. is underleveraged. There are many factors that are not
taken into consideration in the spreadsheet that will affect the capital structure policy of the
firm. Factors such as comparative firms, control problems, life cycle, and debt & discipline
theory do not explain Yahoo! Inc.s capital structure. Most of firms in related industries have
a higher debt/equity ratio than Yahoo! Inc. In terms of life cycle Yahoo is a mature firm and is
not so risky anymore and therefore could have higher debt. The debt and discipline theory
could work because most of Yahoo! Inc. shareholders are outsiders unlike Microsoft.
Nevertheless, Yahoo! Inc. has very low debt and it is clear they are not using debt to stimulate
their managers. Managers in the firm seem to be adequately responsive to Yahoo
stockholders. The firm set up and email alert system, which gives investors alerts and instant
access to all the companys financial information and events. Upon signing up for these
alerts, investors will be notified when any important press releases are made public, all SEC
filings, including quarterly and annual reports and large insider transactions, and any
webcasts or events that Yahoo holds such as financial conferences and stockholders
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meetings. Yahoo also allows investors the ability to sign up to have all SEC filings, such as
the 10-K, annual reports and Proxy statements printed and mailed to their household so they
have hardcopies of the information.
However, factors like intangible assets, flexibility, and pecking-order theory can help to
explain Yahoos policy. Since a good portion of Yahoo! Inc.s assets are intangible it has a
higher risk and higher bankruptcy costs. The company should not have as much debt as other
companies with more tangible assets. This could be one reason that explains Yahoo! Inc.s
lower than optimal debt/equity ratio. Also Yahoo has made good investments in the past,
which was only possible because of the flexibility the company had. Yahoo! Inc. has bought
and resold several companies. One of the most recent and successful investment projects was
the investment in Alababa Group.
The pecking-order theory could explain why it does not have much debt. According to the
pecking-order theory managers prefer to use internal funds to finance investments if possible
over debt and equity. Therefore if the company had enough internal funds to support its
investments it never had much need for debt.
Yahoo has other deductions to reduce the tax bite. The main one being depreciation of
$481M. This might be another reason as to why Yahoo! Inc. has decided to not take so much
debt. The depreciation definitely helps to soften the effect of taxes. Following the trade-off
theory Yahoo! Inc. might believe that their tax shield is sufficient and their risk of bankruptcy
is too costly and outweighs the use of more debt.
How easy is it for bondholders to observe what equity investors are doing? Are the assets
tangible or intangible? If not, what are the costs in terms of monitoring stockholders or in
terms of bond covenants?
It is relatively easy for bondholders to observe what equity investors are doing because the
information is easily found in the 10-K and the other quarterly reports. The firm has both
tangible and intangible assets. According to the companys balance sheet, goodwill and
intangible assets account for $5,132,210,000 of their total $14,905,795,000 worth of assets so
there is a fairly even breakdown of intangible and tangible assets. Throughout 2012, Yahoo
continued to purchase more intangible assets, such as intellectual property rights and
developed technology, which saw amortization expenses for the company rise 7% compared
to the year before.

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How well can this firm forecast its future investment opportunities and needs? How much
does it value flexibility?
The firm values flexibility very much. As recently as the end of the third quarter of 2013,
Yahoo generated free cash flow of $249 million and returned an additional $1.7 billion to
shareholders through buybacks. Their balance sheet had $3.2 billion in cash and securities,
which made them well positioned with ample liquidity to fund future investments for growth.
Yahoo has more than $4.5 billion dollars of long-term investments alone according to their
balance sheet for the end of quarter three. With more than $3.2 billion in cash and securities,
they have a lot of financial flexibility should any good opportunities arise for them to make
smart investments regarding their future.
4. Recommendations regarding firms capital structure.
The main recommendation we can make regarding the firms capital structure would be to
add more debt. Following the idea that debt does indeed add discipline to a company and to
the companys managers, Yahoo has room to add more debt and still be able to deal with it
comfortably, while it gives them incentive to work harder, invest smarter and grow more
rapidly in the future. Looking at Yahoos total debt of roughly $121,000,000 and comparing
that to companies in the same industry, such as Microsoft and Google, who have debts of $16
billion and $7 billion dollars respectively, Yahoos debt is far less than both of them. From
seeing the rapid growth of Google into one of the largest companies in the world, with a stock
price of over $1,000, Yahoo may want to look into a larger debt as that may be one of the
reasons why Google is growing at such a rapid pace and why their stock prices have
skyrocketed in recent times.
Of course there would be negative results that come from raising the debt as well (especially
if debt is raised by too much), such as higher risk of bankruptcy (higher bankruptcy costs),
less flexibility. In addition, too much debt could lead to problems like debt overhang. All
considered we still believe the benefits outweigh the risks and Yahoo! Inc. needs to use more
debt as part of the capital structure.

Summary of Analysis and Recommendations

1. Our analysis shows that most large companies in the Internet industry are underleveraged.
Low debt ratio is hurting the companies profitability. In recent years some companies began
to realize that using tax shields can be beneficial. However, they use other ideas than debt tax
shield. Google, for instance, has been paying taxes in countries with lower tax rates for last 4
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years. We think that one of the reasons why managers do not use debt tax shield is that they
think that the capital cost of using internal funds is lower than issue debt. Based on this view,
managers will overuse the internal funds. For those companies, our recommendation will be
issue more debt to increase the companies profitability. There are also some natural reasons
for not using debt. These may include agency cost of debt and loss of flexibility. However,
many companies are underleveraged even taking other factors into consideration.
2. Most small companies in the Internet industry are overleveraged. So they should have less
debt. For some small companies, the cost of issuing new equity is naturally very high
(asymmetric information problems). However, many companies underestimate long-term
problems of carrying too much debt mostly flexibility loss. Also we think it is a good idea to
use preferred stocks.
3. Third, internet companies can use international financing more efficiently.
International debt has advantages not just for governments but for corporations and
individuals as well. Corporations can raise international debt in different currencies.
The currency differential doesnt just diversify risk, it helps to shop for lower interest rates in
a limitless international market. Rates in international markets are normally lower than
domestic sources of capital. This is largely because there are many major firms and banks
involved in these transactions, creating an inherent stability in the market. In addition, given
the fact that there are many currencies involved in many transactions, the overall risk is lower
to the lending institution, since any fluctuations in the currencies and the local markets are
balanced out by the others. Also international market have greater flexibility. International
capital markets like euro-currency are under no capitalization restrictions. This means there
are no required reserves for all institutions to maintain to cushion their risk. As a result, these
markets can lend 100 percent of their deposits, which is possible given the lack of risk in
comparison to purely domestic institutions. Given the fact that international trade continues
to grow, international markets continue to appear as a good bet to hedge against the
possibility of local currency appreciation or market recessions. Finally, Companies seek a
lower cost of capital through mergers and acquisitions, foreign direct investment, and other
global activities. A competitive cost of capital depends on firm-specific characteristics that
attract international portfolio investors and the liberalization of markets where companies
have the freedom to source capital in liquid markets.
4. Using one theory cannot explain all capital structure strategies of Internet industry
companies. We should use multiple theories to explain the capital structure in this industry.
We find that the optimal capital structure determined by the trade-off theory (spreadsheet
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analysis) usually differs from the actual financing mix we observe in the industry. The
pecking order theory can explain why small firms with no large cash reserves prefer debt to
equity and why well-established and financially healthy firms do not use external financing.
It fails to explain, however, why most companies (especially young and/or growing
companies with large expansionary expenditures) prefer large equity issues to bond issues or
even other types of debt. Signaling theory of capital structure cannot explain why most
internet firms do not use debt as a signal of firm quality. The market timing hypothesis
provides good explanations for timing of firms IPOs. For example, nearly all companies issue
equity through public offerings at opportune times, most notably during the tech craze or
dot.com bubble of the late 1990s. We also see firms undergo public offerings when the
market has recovered from the tech crash of 2000 or at other times when management feels
their stock is overvalued. We see companies make stock repurchases at windows of
opportunities where they believe their stock is undervalued. We feel however, that from a
broader point of view, the market timing theory is limited in explaining firms capital
structure besides IPO decision.
5. Flexibility is underexplored area. Both equity and debt holders do place value on
flexibility, especially in the recent years of turmoil in capital markets. Managers surveys
show that managers value flexibility when choosing their capital structures.
We think new quantitative approaches in valuing flexibility should be developed.
Managers are also concerned about credit ratings, as observed anecdotally in the press and
through survey results. Future capital structure research would benefit from including credit
ratings as part of the capital structure framework, to obtain a more comprehensive depiction
of capital structure behavior.
6. Theories of capital structure should take into account that its been a shift from
shareholders value maximization strategy to stakeholders value optimization. We think that
internet companies demonstrate shift from shareholders value maximization strategy to
stakeholders value optimization. One of the dramatic changes created by the expanding
global economy is the increase in the rate of change within industries.
As more industries are experiencing greater levels of change, we will find the use of
Equity-centered governance will prove less effective in the near future. We feel that this
aspect of behavior is undeveloped especially in North America versus Europe for example.
The first duty of managers is to ensure the long-term survival of the organization within its
competitive environment. In a world devoted to quick fixes, and short-term thinking edited
by sound bites, it is difficult to take time to think through serious challenges. As
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environments become more competitive, those who make the time to reach appropriate
decisions will be the ones left standing.
7. We feel that the Traditional Theories have a lot of room for improvement. The pecking
order theory cannot explain why many firms in internet industry do not prefer debt over
equity. We feel that recent papers about dynamic pecking order theory are promising where
managers may sometime find attractive to issue equity (see, for example, Miglo (2008)).
Next, one needs to develop Dynamic versions of Trade-Off Theory of Capital structure.
Constructing models that recognize the role of time requires specifying a number of aspects
that are typically ignored in a single-period model. Of particular importance are the roles of
expectations and adjustment costs.
In the future, financial economists need to continue developing dynamic versions of each
theory or to develop new models that incorporate both trade-off and pecking order ideas.
More research may be required to create new models that can compete with trade-off and
pecking order theories.
8. Finally, a popular line of inquiry based on surveys of managers about their capital structure
decisions seems to be promising. For example, Graham and Harvey (2001) report a large gap
between theory and practice.
9. In terms of debate about future development of capital structure theory, we disagree with
Harris and Raviv (1991) opinion that asymmetric information theories are less promising. We
feel that existing asymmetric information theories are not sufficient and this is the reason why
these theories have less support than the trade-off theory among managers and students. We
find that asymmetric information is important in explaining many patterns of capital structure
behavior of internet companies but managers do not have a practical tool to use it more
efficiently. At the same time given that the gap between theory and practice is very large, we
agree with Harris and Raviv (1991) in that the door is still widely open for new theory of
capital structure which can be helpful to make a bridge between managers and students which
can be helpful to the future students to know more clear about capital structure.

Conclusions
We analyze the financing decisions and capital structure of internet companies and relate
observed findings to the common capital structure theories. Large internet companies usually
have low debt and small internet companies have high debt. We find that the trade-off theory
of capital structure, pecking order theory, market timing theory and other theories cannot
individually determine a firms capital structure and their use of sources of financing

59

accurately but can compliment each other to help explain observed behavior. We also suggest
a number of recommendations for capital structure theory and practice.

CONCLUSION
The firms are more preferred the external debt financing over the internal debt. Tradeoff
theory urges that internal finance are less available due to low liquidity and firms prefer to
rely on external finance, and hence companies with low liquidity tend to adopt external
financing. We examined different dependent variables of the capital structure such as debt
ratio, short term debt ratio and long term debt ratio, and number of independent variables
such as tax shield, assets structure, profitability, growth opportunities, liquidity, company size
and dividend policy. On the basis of literature determinants under pecking-order theory are
Liquidity, Firm size having negative relation with leverage, and profitability, asset tangibility
having positive effect on the debt-to-capital ratio. On the basis of determinants of capital
structure in static trade-off theory are Non-debt tax shield and Business Risk having negative,
Profitability, Firm size, and Asset tangibility having positive effect on the debt-to-capital
ratio. Assets tangibility, size and age having positive relation with debt-to-equity ratio on the
60

basis of Information Asymmetry theory. Growth having negative relation with the debt-equity
ratio as per agency theory.
We found moderate evidence that companies follow the trade-off theory of capital structure
by setting and attempting to adhere to target debt ratios. But other results, such as the
importance of equity undervaluation and financial flexibility mentioned above, were
generally consistent with the pecking order view that companies issue equity only as a last
resort. However, the evidence in favour of both theories does not hold up as well under closer
scrutiny. For example, although many companies appear to follow a financing pecking order,
our survey produces little evidence that their financing choices are related to the information
disparities emphasized by the model. We also find at best mixed evidence that companies
capital structure choices are influenced by transactions costs, product market concerns, or
costs stemming from potential underinvestment and free cash flow problems. There were,
however, some fundamental differences between large and small companies that suggest that
finance theory may be gaining ground faster among larger companies. Our research suggests
that small firms are less sophisticated when it comes to evaluating risky projects. Small firms
are significantly less likely to use the NPV criterion or the capital asset pricing model and its
variants. And the fact that the majority of large companies (as compared to only a third of
small firms) professed to adhere to target debt ratios also suggests the greater sophistication
of the former (or that the theory simply doesnt fit small firms as well).

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