Corporate Finance Essay

Introduction

Most corporate financing decisions in practice reduce to a choice between debt and equity.
The finance manager wishing to fund a new project, but reluctant to cut dividends or to
make a rights issue, which leads to the decision of borrowing options. The issue with regards
to shareholder objectives being met by the management in making financing decisions has
come to become a major issue of recent times. This relates to understanding the concept of
the agency problem. It deals with the separation of ownership and control of an organisation
within a financial context. The financial manager can raise long-term funds internally, from
the company’s cash flow, or externally, via the capital market, the market for funds of more
than a year to maturity. This exists to channel finance from persons and organisations with
temporary cash surpluses to those with, or expecting to have, cash deficits, i.e. the
shareholders.

The agency problem on a firm’s capital structure decisions

Potential conflict arises where ownership is separated from management. The ownership of
larger companies is widely spread, while the day-to-day control of an organisation’s business
interests rests in the hands of a few managers who usually have a relatively small proportion
of the total shares issued. This can give rise to the problem of managerial incentives.
Examples of this include pursuing more perquisites (splendid offices and company cars, etc.)
and adopting low-risk survival strategies and satisficing behaviour. This conflict has been
explored by Jensen and Meckling (1976), who developed a theory of the firm under agency
arrangements. Managers are, in effect, agents for the shareholders and are required to act
in their best interest. However, they have operational control of the business and the
shareholders receive little information on whether the managers are acting in their best
interest. According to Jensen and Meckling (1976), if a wholly-owned firm is managed by the
owner, he will make operating decisions that maximize his utility. These decisions will
involve not only the benefits he derives from pecuniary returns but also the utility generated
by various non-pecuniary aspects of his entrepreneurial activities such as the physical
appointments of the office, the attractiveness of the office staff, the level of employee
discipline, the kind and amount of charitable contributions, personal relations (friendship,
respect and so) with employees, a larger than optimal computer to play with, or purchase of
production inputs from friends. A company can be viewed as simply a set of contracts, the
most important of which is the contract between the firm and its shareholders. This contract
describes the principal-agent relationship, where the shareholders are the principals and the
management team the agents. An efficient agency contract allows full delegation of
decision-making authority over use of invested capital to management without the risk of
that authority being abused. However, left to themselves, managers cannot be expected to
act in the shareholders’ best interests, but require appropriate incentives and controls to do
so. Agency costs are the difference between the return expected from an efficient agency
contract and the actual return, given that managers may act more in their own interests
than the interests of shareholders.

The capital structure of a firm is divided between debt capital and equity. Debt capital is the
use of borrowed funds by the management of a firm to carry out its financial decisions. Most
companies borrow money on a long-term basis by issuing loan stocks. The terms of the loan
will specify the amount of the loan, rate of interest and date of payment, etc. Equity capital
on the other hand is the long-term finance of a firm which is provided by the shareholders of
a company. By purchasing a portion of, or shares in, a company, almost anyone can become
a shareholder with some degree of control over the company. Ordinary share capital is the
main source of new money from shareholders. For an established business, the majority of
equity funds will normally be internally generated from successful trading. Any profits
remaining after deducting operating costs, interest payments, taxation, and dividend are
reinvested in the business and regarded as part of the equity capital. The finance manager
will monitor the long-term financial structure by examining the relationship between loan
capital, where interest and loan repayments are contractually obligatory, and ordinary share
capital, where dividend payment is at the discretion of directors. This is known as gearing.
There are two basic types of gearing, they are capital gearing which indicates the proportion
of debt capital in the firm’s overall capital structure; and income gearing indicates the extent
to which the company’s income is pre-empted by prior interest charges. Both are indicators
of financial gearing.

Now, the advantages of debt capital centre on its relative cost. Debt capital is usually
cheaper than equity because, the pre-tax rate of interest is invariably lower than the return
required by shareholders. This is due to the legal position of lenders who have a prior claim
on the distribution of the company’s income and who in liquidation precede ordinary
shareholders in the queue for the settlement of claims. Debt is usually secured on the firm’s
assets, which can be sold to pay off lenders in the event of default, i.e. failure to pay interest
and capital according to the pre-agreed schedule; debt interest can also be set against profit
for tax purposes; the administrative and issuing costs are normally lower, e.g. underwriters
are not always required, although legal fees are usually involved. Jenson and Meckling
(1976) argue that if the manager owns only 95 percent of the stock, he will expend resources
to the point where the marginal utility derived from a dollar’s expenditure of the firm’s
resources to the point where the marginal utility derived from a dollar’s expenditure of the
firm’s resources on such items equals the marginal utility of an additional 95 cents in general
purchasing power (i.e., his share of the wealth reduction) and not one dollar. Such activities,
on his part, can be limited (but probably not eliminated) by the expenditure of resources on
monitoring activities by the outside stockholders. They also add that prospective minority
shareholders will realize that the owner-manager’s interests will diverge somewhat from
theirs; hence the price which they will pay for shares will reflect the monitoring costs and
the effect of the divergence between the manager’s interest and theirs. As the owner-
managers fraction of the equity falls, his fractional claim on the outcomes falls and this will
tend to encourage him to appropriate larger amounts of the corporate resources in the form
of perquisites. This also makes it desirable for the minority shareholders to expend more
resources in monitoring his behaviour. Thus, the wealth costs to the owner of obtaining
additional cash in the equity markets rise as his fractional ownership falls.

The issue of asymmetric information to a firm’s capital structure

It follows that, to understand how firms behave, we must understand the nature of the
contracts and monitoring procedures. Information is not usually available to all parties in
business in equal measure. For example, the board of directors will know more about the
future prospects of the business than the shareholders, who have to rely on published
information. Thus information asymmetry means that investors not only listen to the
board’s rhetoric and confident projections, but also examine the information content in its
corporate actions. This signally effect is most commonly seen in the reaction to dividend
declaration and share dealings by the board An increase in dividends signals that the
company is expected to be able to sustain that level of cash distribution in the future. Now,
shareholders and other investors in a business do not possess all the information available
to management. Nor do they always have the necessary expertise to appreciate fully the
information they do receive. Capital rationing may arise because senior managers,
convinced that their set of investment proposals is wealth-creating, cannot convince a more
sceptical group of potential investors who have far less information on which to make an
assessment and who may be influenced by the company’s recent performance record.
According to Myers and Majluf (1977), new-issue dividend reinvestment plans could elicit
negative stock price reactions due to information effects, leverage effects, or downward
sloping long-run demand for shares due. Myers and Majluf (1977) also adds that the
information effects with regard to the possession of information between shareholders and
management, signalling that the firm’s assets are overvalued, and signalling management’s
expectation that the firm’s cash flow distribution will deteriorate in terms of the level of
cash flow distinguished empirically by recognizing that a dividend reinvestment plan issue
should convey information at the same time to both parties (i.e. shareholders and
management). In addition, Myers and Majluf (1977) argue that setting the firm’s
management seeks to sell overvalued shares in order to benefit current shareholders at the
expense of new investors. Adding to the issue of information asymmetry on a firm’s capital
structure decisions, Ross (1977) state that managers naturally have vested interest in not
making the company insolvent, so an increase in gearing might be construed by the market
as signalling a greater degree of managerial confidence in the ability of the company to
service a higher level of debt. This argument relies on asymmetric information between
managers and shareholders, and reflects the pervasive principal/agent problem. Financial
managers, as appointees of the shareholders, are expected to maximise the value of the
enterprise, but it is difficult for the owners to devise an effective, but not excessively costly,
service contract to constrain managerial behaviour to this goal. In the context of capital
structure theory, the financial manager acts as an agent for both shareholders and debt-
holders. Although, the latter do not offer remuneration, they do attempt to limit managers’
freedom of action by including restrictive covenants in the debt contract, such as restrictions
on dividend payouts, to protect the asset base of the company. Such restraints on
managerial decision-making may adversely affect the development of the firm and, together
with the monitoring costs incurred by the shareholders themselves, may detract from
company value. Conversely, it is possible that the close monitoring by a small group of
creditors, aiming to protect their capital, may induce managers to pursue more responsible
policies likely to enhance the wealth of a widely diffused group of shareholders.

The practical methods a firm may use to determine its optimal financing mix

For many years, it was thought advantageous to borrow so long as the company’s capacity
to service the debt was unquestioned. The result would be higher earnings per share and
higher share value, provided the finance raised was invested sensibly. The dangers of
excessive levels of borrowing would be forcibly articulated by the stock market by a down
rating of the shares of a highly geared company. This prompted the concept of an optimal
capital structure which maximised company value. However, while the critical gearing ratio
is thought to depend on factors such as the steadiness of the company’s cash flow and the
saleability of its assets, it has proved to be like the Holy Grail, highly desirable but illusory,
and difficult to grasp.
Capital Gearing

A widely-used measure of capital gearing is the ratio of all long-term liabilities (LTL), i.e.
amounts falling due after more than one year, to shareholders’ funds. This purports to
indicate how easily the firm can repay debts from selling assets, since shareholder funds
measure net assets:

Capital gearing = LTL

Shareholders’ funds

There are several drawbacks to this approach. First, the market value of equity maybe
considerably higher than the book value, reflecting higher asset values, so this measure may
seem unduly conservative. However, the notion of market value needs to be clarified. When
a company is forced to sell assets hurriedly in order to repay debts, it is by no means certain
that buyers can be found to pay acceptable prices. The break-up values of assets are often
lower than those expressed in the accounts, which assume that the enterprise is a going
concern. However, using book values does at least have an element of prudence. In addition,
the dynamic nature of market values may emphasise the case for conservatism, even for
companies with safe gearing ratios. A second problem is the lack of an upper limit to the
ratio, which hinders inter-company comparisons. This is easily remedied by expressing long-
term liabilities as a fraction of all forms of long-term finance, thus setting the upper limit at
100 per cent. A third problem is the treatment of provisions made out of previous years
income. Technically, provisions represent expected future liabilities. Companies provide for
contingencies, such as claims under product guarantees, as a matter of prudence. Provisions
thus result from a charge against profits and result in lower stated equity. However, some
provisions turn out to be unduly pessimistic, and may be written back into profits, and hence
equity, in later years. A good example is the provision made for deferred taxation. This is a
highly prudent device to provide for possible tax liability if the firm were to sell its fixed
assets. Provisions could thus be treated as either equity or debt according to the degree of
certainty of the anticipated contingency. If the liability is highly certain, it is reasonable to
treat it as debt, but if the provision is the result of ultra-prudence (i.e. conservatism), it may
be treated as equity.

Interest Cover and income gearing

The trigger for a debt crisis is usually inability to make interest payments, and the frontline is
therefore the size and reliability of the company’s income in relation to its interest
commitments. Although, in reality, cash flow is the more important consideration, the ability
of a company to meet its interest obligations is usually measured by the ratio of profit
before tax and interest, to interest charges, known as interest cover, or times interest
earned:

Interest Cover = Profit before interest and tax

Interest charges

Strictly, the numerator should include any interest received and the denominator should
become interest outgoings. This adjustment is rarely made in practice; net interest charges
are commonly used as the denominator. The inverse of interest cover is called income
gearing, indicating the proportion of pre-tax earnings committed to prior interest charges. If
a company earns profit before interest and tax of 29 million, and incurs interest charges of 2
million, then its interest cover is (20m / 2m) = 10 times, and 10 percent of profit before
interest and tax is pre-empted by interest charges. Arguably, cash flow-to-interest is a better
guide to financial security, given that profits are expressed on the accruals basis, i.e.,
recognised even through cash may not have been received yet for sales. Hence, the formula
below is sometimes used:

Cash flow cover = Operating cash flow

Net interest payable

Operating and financial gearing

A major reason for using debt is to enhance or gear up shareholder earnings. When a
company is financially geared, variations in the level of earnings due to changes in trading
conditions generate a more than proportional variations in earnings attributable to
shareholders if the interest charges are fixed. This effect is very similar to that exerted by
operating gearing. Most businesses operate with a combination of variable and fixed factors
of production, giving rise to variable and fixed costs respectively. The particular combination
is largely dictated by the nature of the activity and the technology involved. Operating
gearing refers to the relative importance of fixed costs in the firm’s break-even volume of
output. As sales rise above the break-even point, there will be a more than proportional
upward effect on profits before interest and tax, and on shareholder earnings. Firms with
high operating gearing, mainly capital-intensive ones, are especially prone to fluctuations in
the business cycle. In the downswing, as their sales volumes decrease, their earnings before
interest and tax decline by a more than proportional amount; and conversely in the upswing.
Hence, such companies are regarded as relatively risky. If such companies borrow, they add
a second tier of fixed charges in the form of interest payments, thus increasing overall risk,
the higher the interest charges, the greater the risk of inability to pay. Consequently, the risk
premium required by investors in such companies is relatively high. It follows that
companies that exhibit high operating gearing should use debt finance sparingly.

The target capital structure

A solution commonly adopted in practice is to specify a target capital structure. Here, the
firm defines what it regards as the optimal long-term gearing ratio, and then attempts to
adhere to this ratio in financing future operations. If for example, the optimal ratio is
deemed to involve 50 per cent debt and 50 percent equity (i.e. a debt-to-equity ratio of 100
percent), any future activities should be financed in these proportions. For example, a 10
million project would be financed by 5 million debt and 5 million equity, via retained
earnings or a rights issue. The corollary is to use the WACC as the cut-off rate for new
investment. When shareholders require 20% and debt costs 7.0% post-tax, the WACC is:

{Cost of equity × equity weighting} + (post-tax cost of debt × debt weighting)

= (20% × 50%) + (7.0% × 50%) = (10% + 3.50%) = 13.50%.

The WACC is recommended because it is difficult to anticipate with any precision how
shareholders are likely to react to a change in gearing. The somewhat pragmatic solution
proposed assumes that the new project will have no appreciable impact on gearing: in other
words that the company already operates at the optimal gearing ratio and does not deviate
from it.
SUMMARY AND CONCLUSION

This essay has looked at the effect of the agency problem on determining the firm’s capital
structure decisions, i.e. the pursuance of managerial incentives which is seen as a problem;
such as splendid offices, company cars, and lavish life styles, etc, with no direct control by
the shareholders on the activities of the management. Additionally, we have discussed
about the ownership of the firm with regards to the latter mentioned, i.e. if the manager
owned 95 percent of a company, how would that affect the firm’s capital structure
decisions. We have also identified that capital structure is divided between debt capital and
equity. Following, we have also examined the issue of asymmetric information to a firms
capital structure, i.e. when there are two parties to a contract in which one party has more
or all the information regarding an organisations operations and the other party has very
little or no information regarding the previous mentioned; and looking at how that affects
the capital structure of the firm. Finally, practical methods by which management within
firms may use to determine their optimal financial mix are critically analysed. They are
capital gearing, interest cover and income gearing, operating and financial gearing, and
lastly, the target capital structure.

It will be worthwhile to conclude that gearing can lower the overall or weighted average cost
of capital that the company is required to achieve on its operations, and can raise the
market value of the enterprise. However, this benign effect can be relied upon only at
relatively safe gearing levels. Companies can expect the market to react adversely to
excessive gearing ratios. Strictly, the appropriate cut-off rate for new investment is the
marginal cost of capital, but if no change in gearing is caused by the new activity, the WACC
can be used. Also considerable care should always be given when prescribing the
appropriate use of debt that will enhance shareholder wealth without ever threatening
corporate collapse, a major trend with regards to the agency problem. The capital structure
decision, like the dividend decision, is a secondary decision, that is, to the company’s
primary concern of finding and developing wealth-creating projects. Many people argue that
the beneficial impact of debt is largely an illusion. Clever financing cannot create wealth
(although it may enable exploitation of projects that would not otherwise have proceeded).
It may however, transfer wealth if some stakeholders are prepared, perhaps due to
information asymmetry, to accept too low a return for the risks they incur, or if the
government offers a tax subsidy on debt interest. The decision to borrow should not be
over-influenced by tax considerations. There are other ways of obtaining tax subsidies, such
as investing in fixed assets, which qualify for tax subsidies. A highly, geared company could
find itself unable to exploit the other tax-breaks offered by governments when a favourable
opportunity is uncovered.