Week 10: Capital Structure

Before I start to write on this week’s blog, I just want to revise back regarding the topic ‘raising corporate finance’ where this topic has some connection with this week’s blog (related to capital structure).

A company could raise its’ finance by applying the two main ways; by equity finance or debt finance. As a revision, raising finance via equity financing by having investors to issuing shares seems like the best way especially for those who want to expand their business without paying back to the investors but they just need to share the profits or deliver an appropriate return to the investors. However, equity financing may need returns that are higher than the rate that you probably need to pay for a bank loan, plus the cost is more expensive than debt financing and more risky for the investors. In addition, the investors also might want some ownership from the company and this may occur the agency problem where some people in the company might not agree with the investors since they need to discuss first before making any decision with investors.

On the other hand, debt financing (a loan from bank or any lending institution) is cheaper than issuing shares as the issuing and transaction costs is lower and less of debt interest that need to pay due to tax reduction. Applying this form of raising finance also do not have to give up a part of company profit as a return to the investors and they have no right in the company. Apart from this, debt financing is less risky for the lenders as the borrowers are obliged to make repayment of the loan including the interest. Therefore, after all, in order to obtain the optimal capital structure (capital structure= the way a firm finances its’ assets through the equity or debt or combination of both), since debt finance is cheaper, all company may need to do is to increase the gearing level (with the consideration if this changes could increase the shareholder wealth) in order to reduce its’ cost of capital (as a wise firm will use the right way to keep their true cost of capital low as possible).

But, a company has to bear in mind where higher debt or gearing may cause the risk of financial distress costs. Furthermore, the various components of cost of capital is depending on the market values (which change on a daily basis), where then the market values are depending on the firm’s prospects (which it is depends on the investors belief on the success of this activity). A firm prospects are influenced by capital structure, thus, if a firm has too much debt, in which they still need to pay the interest regardless with high or low profits in good or bad years, could result s on interference in creating the shareholder wealth. Overall, increasing the gearing level could give an advantage to the decreasing of WACC, but also may cause the increasing of shareholders’ risks (that thus, they will demand a higher return for the risks they are taking).

Based on the traditional view, decreasing the WACC (merely changing the company’s capital structure) by increasing the gearing level indeed will affect on the increased of the share price, returns per share, value of the company and shareholders’ wealth thus, can attain an optimal capital structure but then, this also tend to increased the risks if the gearing level always rising.

However, Modigliani and Miller stressed that the company’s capital structure has no impact on WACC so, there is no optimal structure exists and that the company’s value is merely depending on the business risks. In addition, their assumptions that there is no taxation (while in real world, individuals and companies need to pay taxes, therefore the introducing of taxation give them additional advantage to using the debt capital-as mentioned before, there is tax reduction by using this form of raising finance), there are perfect capital markets with perfect information available to all people with no financial distress and liquidation costs thus make individuals can borrow as cheaply as corporation. Even so, people cannot rely on their assumptions, as perfect markets do not really exist in the real practice until they have corrected their assumptions in 1963.

Lets have an idea of the importance of the capital structure. In real world, according to the recent news in Bloomberg (April, 2013) where Fiat SpA(F), the Italian car-maker wants to buy the remaining stake in Chrysler Group LLC by cash (considering the disposal of some assets to control its debt) and no issuing new shares. Fiat is also planning to raise its finance via loan from banks. This means that Fiat is structuring its’ capital in the form of debt financing. This is perhaps by raising its finance through debt finance, they would get better benefits from it to their business rather than use the equity finance. However, the management may affect on some factors on borrowing decisions such as, capacity to borrow, managerial preferences, pecking order, financial slack, signalling, control, industry group gearing, motivation, reinvestment risks, operating and strategic efficiency as their business sales was slightly worse last year. In addition, the CEO of this company believes that to close with the deal (buy remaining stake in Chrysler Group LLC), its capital structure has to be looked at for the long term in order to survive the business in a long run.

Therefore, considering the company’s capital structure carefully is important for those who want to success and sustain their business in the long lifetime..