Importance Of Capital Structure And Cost Of Capital Finance Essay

INTRODUCTION

Finance is commonly referred to as the life wire of any organization and usually in limited supply. In the parlance of financial management, cash is the most valuable resource and needs to be efficiently managed. The importance of sourcing for finance cannot be over emphasized as lack of it may well result to slow down of operational activities and possible bankruptcy.

There are various sources of finance available to large companies but these sources can be broadly classified into two (that is, debt and equity finance). Firms may use external or internal sources on a long-term or short term basis. The short term financing are outside the scope of this assignment.

Traditionally, companies exist to make profit but this concept is quite narrow and subjective as profit alone does not ensure their survival and interest of all stakeholders. What then do firms try to achieve? That is “maximizing shareholders wealth” which is generally regarded as the objective of firms. (Ross, Westerfield & Jordan 2003)

Efficient Financial Management always seek to achieve this goal as there is a direct co-relation between adding value to shareholders and meeting the needs of all stakeholders [1] . This view is highlighted by the fact that shareholders as owners bear the highest risk and rank at the bottom to receive benefits after other stakeholders. That is to say, they get the left-over. Adams Smith (1776) was one of the earliest to postulate this view; ‘the business man…by pursuing his own interests, frequently promotes that of the society more effectually than when he really intends to protect it’

Also Al Ehrbar (1998) establishes that, in trying to satisfy the selfish interest of one group (in this case, the shareholders), we end up meeting those of other stakeholder. This is the case as we go down the ranking order to equity holders.

Usually, owners of companies (shareholders) appoint/hire managers (agents) to carry on the business of managing their interest (that is value maximization). This agent-ownership relationship is referred to as the “agency theory”. Most often than not, there exist conflict of interest as some agents or managers(whom I wish to describe as damaging directors, in the light of recent collapse of high profile companies) seek to pursue goals other than the owners. Some of these goals are personal and involve engaging in risky decisions to achieve high bonuses. The Agency Theory or recently Corporate Governance issues tend to negate the over all firm objective of maximizing shareholders wealth.

To ensure that agents do what they are hired to do and to improve on Corporate Governance, several code of conducts(modus-operandi) have been put in place by regulatory bodies through the Sarbanes-Oxley Act(USA), Hermes Fund Managers, Cadbury Report etc.

(University of Sunderland Business School APC 308 Financial Management 2007, pp 19-20)

For companies to achieve their over all objective, they must critically evaluate the Capital Structure, Cost of Capital and conduct Project Appraisal for all competing investment decisions. These key issues do not operate in isolation as they are also directly linked with sourcing for and efficient management of finance in terms of associated risks.

This essay is in two parts: A and B, and defines the scope. Part A – covers the “importance of capital structure and cost of capital” and part B – will dwell on the “models of appraising investments”.

PART (A)

COST OF CAPITAL

This is simply the minimum expected rate of return to the providers of finance. When viewed from the company’s perspective this rate is a cost. In order to ensure the efficient management of finance, ascertaining the least possible cost of capital is very pertinent. The rule of thumb here is that for every source of finance available to a company, there is always an associated cost implication. It is also note worthy to mention that there is some relationship between the cost of capital, capital structure and most importantly appraising projects. The expected rate of return (otherwise discount rate) is used to test the viability of projects for investment decisions. This point will be evaluated in part B.

In estimating the cost of capital the time value of money with the risk factor and opportunity cost are considered. A higher risk implies a higher returns (or cost).

Basically, the company’s cost of capital is the Weighted Average Cost of Capital (WACC) and comprises the average costs of all the firms’ sources of finance (that is, cost of debt and equity financing).

Cost of Equity: This is the estimated returns a shareholder expects from investing in a company. Equity owners or shareholders are the owners of the company and enjoy the rights to vote, appoint directors, receive dividend and share in any residual asset. But also bear the highest loss in the event of a receivership.

Estimating this cost involves two approaches: the dividend valuation model and the capital asset pricing model

Dividend Valuation Model(DVM): this model is predicated on the assumption that the share price is the value of the future dividends discounted to today’s value

The expression used for estimating this cost is;

Ke = Di / Po + g

Where, Ke = cost of capital, Di = next year’s dividend

Po = current share price and g = annual dividend growth rate.

This approach relies heavily on the historical data which is readily available and requires little effort to estimate. This is its major advantage (simplicity). On the other hand, the dividend valuation model has a number of short comings, most noticeable is it applies only to firms that pay dividend and this is often not the case. In reality companies may not be making sufficient profit to pay dividend or have it retained. The model also assumes a constant growth rate. Share prices are highly volatile and not very reliable to base predictions. Furthermore, it plays down the risk factor assuming that share prices exist in an efficient capital market. This last assumption is a subject of debate as there is implicit risk associated with the use of current share price in its computation. (Ross, Westerfield & Jordan 2003, pg 497)

Capital Asset Pricing Model (CAPM): this is a more suitable approach to estimate the cost of equity than the dividend valuation model as risk is core element. It is a mathematical model that estimates the return expected from an asset (security) relative to the security risk (referred to as the beta).

It is expressed by the Security Market Line (SML) and a derivative of the Portfolio Theory. The Portfolio Theory seeks out the best possible mix or combination of assets that will compensate the risk associated with individual security in a portfolio by spreading the risk across board.

That is, the diversification of investments (Markowitz 1952). This is a key role of financial management and demonstrates good stewardship.

The risk elements are of two types: Systematic Risk [2] and Unsystematic Risk [3] 

The SML is a line graph which indicates the relationship between the risk (beta) and the expected returns. This line also highlights the Risk Premium (which is the incentive for an investor accommodating extra risk, in the form of an opportunity cost for not investing in a low risk security).

This model estimates the expected return using the expression:

Re = Rf + βe (Rm – Rf)

Where Rf is the risk-free rate,

βe is the beta (systematic risk) and

(Rm – Rf) is the risk premium

Unlike the DVM, CAPM is very sensitive to risk, thus its advantage is the ability to adjust for risk. Also it is useful to even companies that do not pay dividend.

On the other hand, it still relies largely on past events (historical costs) and these are not reliable indices for predicting future trends. Furthermore, CAPM is founded upon some set of assumptions (such as the absence of tax and zero unsystematic risk). These in reality are not achievable as all companies are legal obliged to pay taxes and. Despite these short comings, CAPM is still widely used by potential investors as it provides a good idea of the measure of risk possible in a particular investment decision.

Cost of Debt: This is the interest charge on company’s borrowings or by the lender of finance. Usually, these borrowings could be from bank loans, debentures or bond options. The cost of debt provides potential investors useful information as it shows the measure of risk associated with a firm. Very risky companies or those perceived to be so, normally bear high interest charges. Debt capital has significant cost implications on the company’s cash flow and the over all outlook of its capital structure (gearing). It has to be properly managed as it is usually linked to distress and bankruptcy problems.

It is also of importance to mention other costs such as; cost of preferred stock and retain earnings.

Preference Stock is classified under equity finance but has the characteristics of debt. Unlike common stockholders, they do not have voting rights and rank below debt but before common stock. They are also entitled to fixed interest which gives it debt characteristics. It’s not very popular nowadays because it has no tax advantage unlike interest on debt that is tax deductible. However, it has some usefulness due to its flexibility.

Retained earnings represent the opportunity cost to the shareholders if they had received it as dividend and possibly invest somewhere else. It is part of profit held back by the company and not distributed to the owners.

************ possible discussion of debt and equity arguments**************

The Weighted Average Cost of Capital (WACC):

This is the minimum returns expected by the various providers of finance. It is the average weightings from the combinations or components of the company’s capital structure and by which an investment decision is expected to return. Also, is the sum average of our cost of debt and our cost of equity in proportion to their capitalization.

Expressed as;

(Cost of debt Ã- proportion of debt) + (cost of equity Ã- proportion of equity)

The WACC works on the assumption that the company draws from a single pool of capital with an associated weighted cost to finance various projects.

A simple example to highlight this point is; if we assume a certain company XYZ is financed by £50 million debt and £50 million equity and invested £100 million in a project. Suppose the debt and equity holders expect a 10% and 20% returns respectively.

Using the expression above, then the overall return (WACC) will be 15% (that is, £5 and £10 to debt and equity respectively)

The WACC is an important investment tool in the hands of analyst and financial managers as it is used to discount expected project cash flows to ascertain their viability.

The underlying principle is not to undertake any project or investment that will not at least return the cost of capital. That is to say, if the returns exceed the WACC then value is been added to investors but if less, it should be abandoned as it implies putting investors funds at risk.

The WACC though widely used is not suitable enough to be the only basis for appraising projects and investment decisions. Trying to predict the future based on historical events is a very slippery ground and the WACC tries to do just that. From our example stated above, it can be seen after a closer observation that the average weighting of the debt and equity costs of 15% may not actually meet the expectations of debt and equity holders ( debt require 10% and equity 20%). Some researchers have studied this loophole and tried to proffer solutions;

“…the necessary cash flow (normal profit) implied by the WACC is inadequate to provide the cash flows to the individual sources of finance when considered separately…WACC is a linear approximation of a non-linear relationship”

(Richard A. Miller, 2006)

This position becomes glaring when a project or investment returns exactly the cost of capital (as estimated by WACC) and has to be apportioned to individual providers of finance. It is obvious in this respect that our 15% will not satisfy 10% debt holders and 20% equity holders separately.

In summary, this problem not withstanding, the WACC should be used with other economic and financial management techniques to meet stakeholders’ expectations until such a time when there is a better alternative.

CAPITAL STRUCTURE

The capital structure refers to the composition of the various sources of finance a company has and usually expressed as a ratio. That is the Debt to Equity ratio, otherwise known as gearing or leverage.

This debt to equity ratio is very key as it implies efficient financial management in the sense that, financial managers should choose a composition that seeks to maximize shareholders wealth by adding value to the firm.

Capital structure decision most often is about the amount of debt the company wants to show on its balance sheet [4] and has impact on the cost of capital. As the capital structure changes so does the cost of capital.

Traditionally, it was considered industry “best practice” to have more debt (high leverage) as this tend to lower the WACC and has good incentives for stock holders. But as the business grows it could become more problematic. Leveraging shows how much debt a company is relying on and very high gearing [5] may indicate a “red flag” caution signal.

Significant research works have been carried out on the subject of capital structure. The most outstanding to date was that of Miller and Modigliani (1958), as they proved that leveraging and capital structure have no effects on a firm’s value other than its investment decisions. As companies continue to bring in cheaper debt, equity holders penalize them by demanding higher returns or costs as a punishment for greater risk exposure. This has a cancelling effect on the gains of increased leverage.

Thomas F. Huertas (2010) recently argued that this indifference to the capital structure will not hold for large financial institutions like banks. Imperfections abound and the market place is no exception. Corporation tax which is mandatory and possible bankruptcy costs are issues that make capital structure relevant. Leverage affects cash flows as companies try to meet their debt obligations until it gets to the point where equity holders fidget due to bankruptcy risk and bail out (by off loading their shares). This development drops the share price value and ultimately the firm’s value.

There are other theories of capital structure (like the trade-off theory and pecking order theory) but are outside the scope of this essay.

In so far as these imperfections exist, efficient management must constantly seek to achieve the least cost of capital (WACC) within the company’s capital structure that will maximize shareholders wealth. This leads us the question of Optimal Capital Structure (OCS).

Does Optimal Capital Structure exist? And if not how can it be achieved?

Companies may want to have some degree of debt (as interests on it are tax deductible) and also maintain caution with reasonable level of equity. This balance is to enable them enjoy the benefits offered by both. Obtaining a perfect mix may prove a daunting task as the pendulum keeps swinging between debt and equity.

In practice, firms try to achieve an optimal capital structure by lowering leverage, usually by converting its hybrid finance (such as preference stock and some class of bonds) to common stock. This is very convenient in times of distress and to minimize cash outflows. This is quite possible as these hybrids posses the characteristics of debt and equity.

A recent case in point to site is that of Unilever N.V, (a major player in the food and beverages sector of the capital market based in Rotterdam-Holland) in their press release. The company is seeking to improve its capital structure by converting some preferred stock to equity. This is restructuring will increase shareholders economic interest. (Uniliver, 2010) [6] 

The incentive in this type of restructuring for the company is to stabilize the business making it more likely to survive and concentrate on profitable ventures. To the investor, promise of greater capital gains from future share appreciations may be the incentives.

Also, earlier this year, the $35.5billion [7] high profile acquisition of AIA (a subsidiary of AIG) by Prudential plc (a UK based Insurance firm) through some equity and debt financing will change the combined business capital structure outlook.

In summary, obtaining an optimal capital structure will be quite impossible practically except on a theoretical basis. But as long as companies strive to maximize shareholders value they should be able to achieve a mix that works.

PART (B)

MODELS OF APPRAISING POTENTIAL INVESTMENTS

Estimating an appropriate capital structure and the least cost of capital to achieve company goals leads to an important question – which is; how to allocate or channel its pool of finance and what investments, assets or projects should be undertaken?

This is where investment decision comes in and it is very central as the goal of efficient financial management is to increase shareholders value. Investment decisions usually involve long-term commitment of capital and if wrong may be disastrous (Drury Collin 2002). The usefulness of the WACC comes to play as the discount rate used in some techniques to appraise the viability of projects.

In making these decisions, certain models have been developed to assist managers, by carefully weighing the potential risks and rewards associated with possible course of actions.

Basically, the models for appraising projects are broadly of two types;

Non-discounted cash flow method – that is, Payback period and Accounting or the Average Rate of Return(ARR)

Discounted cash flow method – that is, Net Present Value(NPV) and Internal Rate of Return(IRR)

Payback Period: As the name signifies, it is the period the cash flows from a project recovers its initial cost.

The decision rule is to accept the project with the shortest payback period.

This technique is widely used because it’s easy to understand and calculate. Another noticeable merit is that it reduces liquidity problem by making funds available quickly for other investments. Also has the potential of eliminating risks and uncertainty associated with the future by early payback.

On the other hand, its major demerit is that it completely ignores the time value of money. As cash flows above the payback period are not considered. Also, the “hurdle rate” in this case the pre-set period required is randomly chosen and has no relationship with the cost of capital. Based on its decision criteria, it could lead to rejecting potentially profitable projects. Researchers tried to improve on its deficiencies by discounting the cash flow.

With all these in mind, the payback is far off the mark to maximize shareholders wealth as it proves to be very limited.

Accounting or Average Rate of Return (ARR): This technique takes a detour from cash flows and makes use of accounting profit.

Different computations methods abound but an easy formula is to divide the average annual profit by the average investment expressed as a percentage.

The decision rule here is to accept a project with ARR above a pre-determined target or hurdle rate.

The upside of this technique is that it factors in depreciation and been expressed in percentage terms makes it quite attractive to work with. Also, data for its computation are readily available and accessible from the financial statements.

On the downside just like its predecessor (payback period), it also falls short of maximizing shareholders wealth. It does not factor in the time value of money and uses an arbitrary hurdle rate which is not a real rate of return. It relies completely on historical information like profit which is more subjective than cash flows.

Net Present Value (NPV): This is simply the present value of all future cash flows subtracted from its cost. In another way, it is discounting future cash flows to its present value and comparing with its initial cost to get a net value.

The underlying principle is to accept a project with a positive NPV otherwise reject.

The implication here is that a positive NPV usually will satisfy a return greater than the cost of capital thus results to maximizing shareholders wealth.

This technique is not flawed by the deficiencies of the non-discounted cash flows as it factors in the time value of money and uses a rate of return which matches the company’s objective function. Additionally, this technique factors in the projects cash flows through out its life cycle, thus over coming the limitations of ARR and Payback periods. Cash flows are more reliable as are less prone to manipulations unlike profit.

The superiority and versatility of NPV over the non-discounted models does not immune it entirely from certain pitfalls. Notably, it does not involve taxes and transaction costs. Also, cash flows and discount rates are estimates and not quite straight forward to ascertain. Also it assumes that investors always want to maximize value.

Internal Rate of Return (IRR): This is another technique using discounted cash flows and regarded as an alternative to NPV. It seeks to determine a rate generated only from a particular project cash flows internally and not elsewhere.

It is the rate when the NPV is zero, involves a trial and error approach which may be one of its demerits.

The decision rule is to accept an investment when the IRR outweighs the pre-set hurdle rate and reject if contrary.

This technique also has links to the projects cost of capital and minimum rate of return. The IRR also has the advantage of been expressed in percentages for ease of interpretations other than in Pounds or Dollar terms.

But the IRR has the problem of generating multiple rates when dealing with successive positive and negative cash flows. This creates a further problem of what rate to choose. The IRR may also fail to guide adequately when comparing two or more projects. Little wonder, it is an alternative to the NPV.

Interestingly, there is a notable relationship between NPV and IRR. This association is highlighted when we plot the series of NPV against their corresponding discount rates on a graph [8] . It will be observed that an increase in the discount rate results to a decrease in NPV. The point where the line intersects the X-axis is the IRR (and NPV equals zero). This typically illustrates a similar decision rule between the two.

A survey conducted by Graham and Harvey (1999) [9] of large firms showed that large percentage of companies use more of the discounted techniques.

From the aforementioned models, we can say that the merits of discounted appraisal model far out weighs those of non-discounted models and more suitable in achieving and creating shareholders wealth.

CONCLUSION

All the appraisal techniques have one common denominator – predicting future outcomes. The future as we know is outside the control of any sophisticated evaluation model and no direct link between outstanding company results and their use has been established. Although some ailing company’s showed signs of improvement by introducing discounted cash flow techniques (Haka S.F 1987).

Potentially, other factors like the decision making process (which has to do with identification, development and operations of project) can greatly undermine the use of these techniques.

No matter how plausible an appraisal technique, it takes quite some convincing to get it through approval. In practice, management of companies may have different ideas or objectives other than just relying on estimates and evaluation.

This is a question we can ask in the face of recent collapse of high profile companies widely accredited with the use of sophisticated models or techniques and skilled consultants.

The models are quantitative in nature, trying to simulate reality in a controlled state and prone to qualitative questions of “internal politics”.

However, there is the constant interplay between the cost of capital, capital structure and appraisal techniques as their use indicates efficient financial management practice in a company.