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Capital structure determinants in practice - CAPITAL STRUCTURE THEORIES
Financial Management - CAPITAL STRUCTURE THEORIES
Capital structure determinants in practice - CAPITAL STRUCTURE THEORIES
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The capital structure determinants in practice may involve considerations in addition to the concerns about earning per share, value of the company and cash and funds flow.
Capital
structure determinants in practice
The capital structure determinants in practice may involve considerations in addition to the concerns about earning per share, value of the company and cash and funds flow.
A company may have enough debt servicing ability but it may not have assets to offer as collateral. Management of companies may not willing to lose their grip over the control and hence they not be taking up debt capital even if they are in their best interest.
Some of the very important considerations are briefly covered below:
Companies with growth opportunities may probably find debt financing very expensive in terms of interest to be paid and this may arise due to non availability of adequate unencumbered collateral securities. This may result in losing the investment opportunities.
High growth companies may prefer to take debts with lower maturities to keep interest rates down and to retain the financial flexibility since their performance can change unexpectedly at any point of time. They would also prefer unsecured debt to have flexibility.
Strong and mature companies have tangible assets and stable profits. Thus they may have low costs of financial distress. These companies would therefore raise debts with longer maturities as the interest rates will not be high for them and they have a lesser need of financial flexibility since their performance is not expected to be altered suddenly. They would also be availing the interest tax shields which in turn will enhance the value of the companies.
The assets and the form of assets held by the companies are very important determinants of their capital structure.
Tangible unencumbered fixed assets serve as a collateral security to debt. In the event of any unforeseen financial distress, the creditors can have recourse to these assets and they may be able to recover their debt by foreclosing such assets.
Companies with large tangible assets will have very less financial distress and costs and they will be preferred by the creditors.
Companies with intangible assets will not have any such advantages
The tax provisions provide for deduction of interest paid on debt and therefore the debt capital can increase the company’s after tax free cash flows. Therefore this interest shield increases the value of the company.
This tax advantage of debt implies that companies will employ more debt to reduce tax liabilities and increase value. In practice this is not always true as is evidenced from many empirical studies.
Companies also have non debt tax shields like depreciation, carry forward losses, etc. This implies that companies that have larger non debt tax shields would employ low debt as they may not have sufficient taxable profit to have the benefit of interest deductibility.
However, there is a link between non debt tax shields and the debt tax shields because companies with higher depreciation would tend to have higher fixed assets, which serve as collateral against debt
Companies will normally have a low level of threat or insolvency perception even though their cash and funds flows are comfortable. Despite this, the companies may exercise conservative approach in their financial leverages since the future is very much uncertain and it may be difficult to consider all possible scenarios of adversity. It is therefore prudent for the companies to maintain financial flexibility as this will enable the companies to adjust to any change in the future events.
The creditors providing the debt capital would insist for restrictive covenants in the long term loan agreements to protect their interest. Such covenants may include distribution of dividends, new additional external finances (other than equity issue) for existing or new projects, maintain working capital requirements at a particular level. These covenants may therefore restrict the companies’ investment, financing and dividend policies. Violation of these covenants can lead to serious adverse consequences. To overcome these restrictive covenants, the companies may ask for and provide for early repayment provisions even with prepayment penalty provisions in the loan agreements.
In designing a suitable capital structure, the management of the companies may decide and desire to continue control over the companies and this is true particularly in the case of first generation entrepreneurs. The existing management team not only wants control and ownership but also to manage the company without any outside interference. Widely held and closely held companies may opt to pursue appropriate strategies to hold back their existing management controls.
Issue or floatation costs are incurred when a company decides to raise debt capital in the market. These debt issue costs are normally expected to be lower than equity issue costs. This alone will encourage the companies to pursue debt capital. Retained earnings do not involve issue costs. The source of debt also influences the issue costs. Regulations like stamp duty on commercial paper or certificate of deposits may also jack up the issue cost for the companies.
Thus companies will prefer to go after debt capital for the following reasons
1. Tax deductibility of interest (availability of tax shield)
2. Higher return to shareholders due to gearing
3. Complicated, time consuming procedure for raising equity capital ӹӹ No dilution of ownership and control
4. Equity results in permanent commitment than debt
The capital structure determinants in practice may involve considerations in addition to the concerns about earning per share, value of the company and cash and funds flow.
A company may have enough debt servicing ability but it may not have assets to offer as collateral. Management of companies may not willing to lose their grip over the control and hence they not be taking up debt capital even if they are in their best interest.
Some of the very important considerations are briefly covered below:
Growth potential
Companies with growth opportunities may probably find debt financing very expensive in terms of interest to be paid and this may arise due to non availability of adequate unencumbered collateral securities. This may result in losing the investment opportunities.
High growth companies may prefer to take debts with lower maturities to keep interest rates down and to retain the financial flexibility since their performance can change unexpectedly at any point of time. They would also prefer unsecured debt to have flexibility.
Strong and mature companies have tangible assets and stable profits. Thus they may have low costs of financial distress. These companies would therefore raise debts with longer maturities as the interest rates will not be high for them and they have a lesser need of financial flexibility since their performance is not expected to be altered suddenly. They would also be availing the interest tax shields which in turn will enhance the value of the companies.
Assets
The assets and the form of assets held by the companies are very important determinants of their capital structure.
Tangible unencumbered fixed assets serve as a collateral security to debt. In the event of any unforeseen financial distress, the creditors can have recourse to these assets and they may be able to recover their debt by foreclosing such assets.
Companies with large tangible assets will have very less financial distress and costs and they will be preferred by the creditors.
Companies with intangible assets will not have any such advantages
Non debt and debt tax shields
The tax provisions provide for deduction of interest paid on debt and therefore the debt capital can increase the company’s after tax free cash flows. Therefore this interest shield increases the value of the company.
This tax advantage of debt implies that companies will employ more debt to reduce tax liabilities and increase value. In practice this is not always true as is evidenced from many empirical studies.
Companies also have non debt tax shields like depreciation, carry forward losses, etc. This implies that companies that have larger non debt tax shields would employ low debt as they may not have sufficient taxable profit to have the benefit of interest deductibility.
However, there is a link between non debt tax shields and the debt tax shields because companies with higher depreciation would tend to have higher fixed assets, which serve as collateral against debt
Financial flexibility
Companies will normally have a low level of threat or insolvency perception even though their cash and funds flows are comfortable. Despite this, the companies may exercise conservative approach in their financial leverages since the future is very much uncertain and it may be difficult to consider all possible scenarios of adversity. It is therefore prudent for the companies to maintain financial flexibility as this will enable the companies to adjust to any change in the future events.
Loan agreements
The creditors providing the debt capital would insist for restrictive covenants in the long term loan agreements to protect their interest. Such covenants may include distribution of dividends, new additional external finances (other than equity issue) for existing or new projects, maintain working capital requirements at a particular level. These covenants may therefore restrict the companies’ investment, financing and dividend policies. Violation of these covenants can lead to serious adverse consequences. To overcome these restrictive covenants, the companies may ask for and provide for early repayment provisions even with prepayment penalty provisions in the loan agreements.
Control
In designing a suitable capital structure, the management of the companies may decide and desire to continue control over the companies and this is true particularly in the case of first generation entrepreneurs. The existing management team not only wants control and ownership but also to manage the company without any outside interference. Widely held and closely held companies may opt to pursue appropriate strategies to hold back their existing management controls.
Issue costs
Issue or floatation costs are incurred when a company decides to raise debt capital in the market. These debt issue costs are normally expected to be lower than equity issue costs. This alone will encourage the companies to pursue debt capital. Retained earnings do not involve issue costs. The source of debt also influences the issue costs. Regulations like stamp duty on commercial paper or certificate of deposits may also jack up the issue cost for the companies.
Thus companies will prefer to go after debt capital for the following reasons
1. Tax deductibility of interest (availability of tax shield)
2. Higher return to shareholders due to gearing
3. Complicated, time consuming procedure for raising equity capital ӹӹ No dilution of ownership and control
4. Equity results in permanent commitment than debt
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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