Debt finance’s advantages and disadvantages to key stakeholders

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1.     Question 1 Definition of the term gearing…………………………………………………….. 3

2.     Question 2 Debt finance’s advantages and disadvantages to key stakeholders….. 4

2.1           Debt finance’s advantages and disadvantages to the firm………………….. 4

2.1.1     Advantages……………………………………………………………………………. 4

2.1.1.1 Tax shield………………………………………………………………………… 4

2.1.1.2 Mitigate the manager stockholder conflicts…………………………. 4

2.1.1.3 Positive influence on R&D activities………………………………….. 5

2.1.2     Disadvantages………………………………………………………………………… 5

2.2           Debt finance’s advantages and disadvantages to the owners………………. 6

2.2.1     Advantages……………………………………………………………………………. 6

2.2.2     Disadvantages………………………………………………………………………… 7

2.3           Debt finance’s advantages and disadvantages to the lenders………………. 7

2.3.1     Advantages……………………………………………………………………………. 7

2.3.2     Disadvantages………………………………………………………………………… 7

3.     Debt to equity ratios in business: The methods of optimal capital structure………. 8

3.1           Net operating income approach………………………………………………………. 8

3.2           Net income approach…………………………………………………………………….. 9

3.3           Cost of capital approach………………………………………………………………… 9

3.4           Comparative ratio analysis……………………………………………………………. 10

4.     Optimal capital structure study in Gemini PLC……………………………………………. 11

4.1           Optional weighted average cost of capital (WACC)…………………………. 11

4.1.1     Computing the cost of debt……………………………………………………. 12

4.1.2     Computing the cost of equity…………………………………………………. 13

4.1.3     Computing the weighted average cost of capital (WACC)…………. 15

4.2           The optimal capital structure identified and other factors…………………. 17

4.2.1     Industrial average debt to equity ratio……………………………………… 17

4.3           Refine the managerial decisions…………………………………………………….. 17

4.4           Global and national capital market segmentation…………………………….. 18

4.4.1     Capital market imperfection……………………………………………………. 18

4.4.2     Government restriction………………………………………………………….. 18

4.4.3     Love for own country……………………………………………………………. 19

4.4.4     Access to the necessary information and channels…………………….. 20

 

 

 

 

1.        Question 1 Definition of the term gearing

Companies can raise finance either though:

Debt, i.e. borrowing money on which they pay the interest
Equity, i.e. from shareholders who are rewarded both by dividend payments and capital growth of the company (Spencer & Stradling 2001, p. 70).

And the term gearing according to John Whiteley (2004, p.252) is a key indicator of a company’s financial structure and refers to the relative proportion of equity capital and loan capital. A similar concept is capital structure which refers to the composition of long term sources of funds such as debentures, long term debt, preference share capital, and equity share capital. And it is believed that these companies that do not plan their capital structure and instead it develops as a result of financial decisions taken by the financial manager without any formal planning may prosper in the short term but ultimately will face considerable difficulties in capital raising  to power their business activities (Hussain 1985, p. 34).

Capital gearing plays an important role in ensuring that a business achieve the success. It is proposed that at the initial stages, a low capital gearing ensures the successful running of a company and helps in protecting the interests of equity shareholders. The income of a newly promoted company is low in the beginning and subject to frequent fluctuations. Therefore a low-geared company with low proportion of fixed cost capital is relieved of the fixed liabilities adversely affecting the company’s income. However, high gear is necessary for the development and growth of an enterprise in the long run as the size of the income becomes more and regular (Brigham & Gapenski 1998, p. 89). For a company that is operating normally with general profit and low possibility of fluctuations, debt financing play a key role in making the business a greater success but it is with disadvantages as well as advantages which we would focus on talking about below.

 

2.        Question 2 Debt finance’s advantages and disadvantages to key stakeholders

 

2.1    Debt finance’s advantages and disadvantages to the firm

 

2.1.1            Advantages

 

2.1.1.1      Tax shield

One advantage of using debt finance is the tax deductible debt if a firm pays taxes and the interest is tax deductible. This is also called as tax shield, the tax shield is valuable because it reduces the net income of the company that goes to the government in the form of taxes. In any given year, this is the product of the tax rate and the interest expense (Fabozzi & Drake 2009, p. 409). For example, if a company earn 100,000 dollar each, it can raise debt of 50,000, and the tax rate is 30%, hence the tax deduction enjoyed by the company would be (100,000 – 50,000) * 30% = 15,000. Therefore, if the company is able to meet the interest charge, then returns to the shareholders are increased by increasing debt and from the view point of the company, it makes the debt financing significantly cheaper than the equity financing.

2.1.1.2      Mitigate the manager stockholder conflicts

One more advantage of using the debt financing is that it can mitigate the manager stockholder conflicts and increase the value of the company. It is believed that managers and shareholders have different objectives in particular managers tend to value investment more than shareholders do. Although there are a number of potentially powerful internal mechanisms to control the managers, the control technology normally does not permit the costless resolution. But, the cash flow identity implies that constraining financing, hedging, and payout policy place indirect restrictions on investment policy places indirect restriction on vestment policy (Danthine & Donaldson 2005, p. 31). This is accordance with Jensen (1986)’s finding that that debt financing can increase the firm value by reducing the free cash flow. This advantage of the debt financing to save the cost is easy to understand, actually it is the same for everyone in the daily life, if we are owing money to others, we will tend to tighten the spend especially those that are not necessary. The same scenario happens to the manager when the company does not provide enough of free cash for allocating and therefore they will concentrate the spending on the necessary items which could not be cut.

2.1.1.3      Positive influence on R&D activities

From a certain point of view, R&D investment have been viewed as with high risk of failure and intangible such that managers may not be interested in firms if the cash flow is not abundant, in such cases, the underdevelopment probably occur than the physical investment leading to negative impacts (Lee, C. F. & Lee, A. C. 2010, p.831). While the R&D activities usually involve high risks, companies would prefer to use the debt financing to cover the R&D expenses.

2.1.2            Disadvantages

While the demand of bonds are investment in the financial market in the eyes of the investors, it enabled the corporates to obtain funds at comparatively low cost, and also the bond interest charges are deductible before calculating the corporate profit tax, the usage of the debt financing at the same time binds the company to the obligation of periodically meeting fixed interest charges and to the repayment of the principal as agreed. The obligations will add certain rigidity to the financial operations and increase the financial risk of the firm (Guerard, Guerard & Schwartz 2007, p. 208). The inability to fulfill the obligations definitely would become a business failure when the company’s investment using the debts raised fund does not prove to be a success and the company does not prepare the backup fund for the failure of the risk investment.

 

2.2    Debt finance’s advantages and disadvantages to the owners

 

2.2.1            Advantages

Borrowing from a bank or selling bonds to raise funds is known as debt financing while issuing stock to raise funds is known as equity financing. Equity financing is an alternative to debt financing but is it not free because when a firm sells equity, it sells ownership of the firm (Grossman & Livingstone 2009). And from the view of the shareholders or owners, debt finance holds the attraction that debt financing tends to be cheaper than equity financing. Providers of loans such as the banks will not share in any capital growth of the company and their return being limited to the interest agreed when the loan was originally made (Spencer & Stradling 2001, p. 70). And hence the return earned by the new shareholders is a cost to the old shareholders. And because of this disadvantage of the equity finance, the debt finance has the advantage of retaining the control and ownership for the shareholders.

Another benefit of debt financing is the effect that it has on profits available for distribution to the ordinary shareholders. The payment of interest on fixed interest capital is a first charge on the firm. But if the money can be borrowed at a 10 per cent and re-invested in a project to earn 12 per cent, there is a distinct advantage to the ordinary shareholders who benefits from the excess 2 per cent. And the larger the proportion of fixed interest capital, the debts, the more pronounced are the benefits (Johnson, Whittam & Crawford 1998, p. 331).The extra profit is the advantage of the debt financing to the owners.

2.2.2            Disadvantages

Shareholders bear financial risk when a company has a capital structure that includes debt. Including debt in a capital structure is known as leveraging the firm (Brigham & Gapenski, 1994) and the risk that shareholders have from a firm becoming leveraged is that return on the equity will be reduced owing to the payment of interest to the bondholders. Hence one disadvantage of the debt financing is the risk that shareholders may receive a lower return on equity owing to interest payments (Vasigh, Fleming & Mackay 2010, p. 270). This disadvantage of the debt financing will definitely exist since the shareholders have to accept such risk in order to possibly enjoy the extra revenue brought by the debt financing investment.

 

2.3    Debt finance’s advantages and disadvantages to the lenders

 

2.3.1            Advantages

Because usually multiple lender are involved in deb finance such as the issue of company bonds, the financing structure also has the risk sharing advantages of syndicated lending (Greenbaum & Thakor 2007, p. 287). And since the shareholders are the owners of the company and the lender are the creditors of the company, their different roles suggest that lenders have priority over the shareholders with respect to the income payments and the apportion of assets on wind up (Adams 2004, p. 73), in this respect the lenders shoulder lower investment risk than the shareholders.

2.3.2            Disadvantages

Agency problems stem from the conflicts of interest, and capital structure management encompasses a natural conflict between stockholders and bondholders. Acting in the stockholders’ best interest might cause the management to invest in extremely risky projects. And by engaging in the risky projects, it is likely that it will lead to a downward revision of the bond rating the firm currently enjoys. And a lowered bond rating in turn would lower the current market of the firm’s bond which will reduce the interest of the bond holders, or the lenders (Keown 2004, p. 373).

3.        Debt to equity ratios in business: The methods of optimal capital structure

The deb to equity ratio is a measure of the long run liquidity of the company or the ability of the company to meet its long term debts. A small proporation of debt to equity indicates that the facility could incur more long term debt provided other things being equal, if needed; whereas a high debt to equity ratio (when compared to the industry) probably shows that the company may have more debt than may be advisable, all other things being equal. And the debt to equity ratio, or the capital structure, is claimed to be of particular interest to the creditors (Allen 2004), though it is also with advantages and disadvantages to other key stakeholders as we have talked about above.

3.1    Net operating income approach

The net operating income approach is used to explain the irrelevance of capital structure by David Durand. According to him, the value of a firm depends upon its operating income and business risk and not on its capital structure. The changes in the capital structure realign the risk and return between the debt and equity and do not alter the total return and the total risk of the firm which impacts its total value (Kapil 2011, p. 295). Three major assumptions are involved in this theory: firstly, the overall cost of the capital will not be changed according to the changes of the debt to equity ratio; secondly, the financial leverage would not have any effect on the value of the company and lastly the financial market will be efficient and no tax would exist. Under such conditions, a company would increase the percentage of debt simply because it is cheaper but the increase of leverage would at the same time increase the financial risk. This theory under a number of assumptions and based on these conditions, it suggests that all capital configurations in term of the debt to equity ratios would be efficient and are all optimal.

3.2    Net income approach

Based on the research of Durand (1959, pp. 91-116), the capital structure options are related to the value of a company. There are also three major assumptions in this approach: first of all, there would not be any taxes imposed on the company; secondly, this theory proposed that the cost of debt will be less than that of the equity or the equity capitalization rate; lastly, the level of leverage would not change the feeling of the investors which could lead to some unexpected responses. And because of these three assumptions, if the cost of equity and cost of debt would not change, the increase of the debt ratio would increase the overall value of the company as well as the owners’ earning. Based on this approach, a company could reach an optimum capital structure which will be the capital mixture in which the value of the firm is the highest while the total cost of capital is the lowest (Khan 2004, p. 15).

3.3    Cost of capital approach

Since a company would use majorly two key methods to source their capital as mentioned previously, equity finance and debt finance, the cost of the capital would also be defined as the total cost of these two capitals in a weighted manner. The cost of capital approach believes that the two important factors need to be taken into account which have been excluded by the above two approaches. The first factor is the risk of leverage should be reflected and perceived by the investors of the company and the second factor is the tax and also tax deduction because of the debts. One more difference is that by changing the debt to equity ratio, the overall cost of the capital would vary, and this approach requires the company to calculate the overall of the capital based on every possible capital structure. A firm borrows more money to fund a given level of assets, debt payments will increase, and equity earnings will become more volatile. This higher earnings volatility, in turn, will translate into a higher cost of equity. In the language of the CAPM (capital asset pricing model) and multi-factor models, the beta or betas we use for equity should increase as the debt ratio goes up. The debt holders will also see their risk increase as the firm borrows more (Damodaran 2011, p. 399). The critical part of using the cost of capital approach would be estimate the cost of equity and cost debt in different debt levels. When the estimations are close to the practical scenarios, the optimal capital structure could be able to be defined by applying the Weighted Average Cost of Capital formula, and when the WACC is minimized, it will be the optimal capital structure and the company value will be magnified.

3.4    Comparative ratio analysis

Business risk is an important factor deciding the optimal capital structure, and also firms in different industries will be exposed to different level business risks. Therefore, we could expect that capital structure to vary considerably across industries. But for sure, in a given industry, capital structure also varies among firms in different market segments (Brigham & Houston 2009, p. 459). And because of the differences of the market which the companies are operating in, a comparative ratio analysis could be applied by comparing a company’s debt to equity ratio with those of a peer group or the industry average level, and size and line of the business are the key criteria for identifying a company’s peers and the market sector that the company is confined to (Fridson & Alvarez 2011, p. 293).

 

4.        Optimal capital structure study in Gemini PLC

Debt / Capital Credit
rating
Pre-tax cost
10% AAA 6.5%
20% AA 7.1%
30% A 7.8%
40% BBB 8.5%
50% BB 10%
60% B 12%
70% C 15%

And,
The risk free rate = 6%
Ungeared equity (debt to equity ratio = 0) Beta (asset beta) is = 0.85
Tax rate = 30%
Expected market return = 14%

4.1    Optional weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) measures the capital discount of a company’s income and expenditure. It is a component of the formula used for calculating the expected cost of new capital and it represents the rate that a company is expected to pay to finance its assets. It is thus the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital (Qfinance.com 2011). Based on this definition, in order for the WACC to be workable to help identify the best capital structure, one basic assumption is that the lowering of the overall cost will lead to a increase of income or else the calculation of weighted average cost of capital (WACC) will be of no meaning.

The formula below is used to calculate the Weighted Average Cost of Capital (WACC) (spreadsheetml.com 2007):

WACC = (Debt / (Debt + Equity)) * Cost of Debt + (Equity / (Debt + Equity)) * Cost of Equity

Equity = Shares Market Price * Shares Issued

Cost of equity = risk free return + market risk premium * Beta

Cost of Debt is usually defined as the after-tax cost of debt:

After-tax Cost of Debt = (1- Tax Rate)* Cost of Debt

4.1.1            Computing the cost of debt

Since After-tax Cost of Debt = (1- Tax Rate)* Cost of Debt, tax rate = 30% and cost of debt (pre-tax) have been provided according to the different debt ratios,

Debt / Capital Credit
rating
Pre-tax cost Tax rate After-tax Cost of Debt
10% AAA 6.5% 0.3 4.55%
20% AA 7.1% 0.3 4.97%
30% A 7.8% 0.3 5.46%
40% BBB 8.5% 0.3 5.95%
50% BB 10% 0.3 7%
60% B 12% 0.3 8.4%
70% C 15% 0.3 10.5%

For example, when 10 per cent of the overall capital is debt, the given pre-tax cost is 6.5%,

After-tax Cost of Debt = (1- Tax Rate)* Cost of Debt = (1 – 0.3) * 6.5% = 4.55%

Two basic consumptions are involved here, firstly, the corporate tax is constant and will be changed if the capital structure changes, secondly, no matter how the capital structure changes, the company would still earn enough profit from the business activities in order to enjoy the tax deduction of the debt.

4.1.2            Computing the cost of equity

In the second step, we compute the cost of equity. The formula applied here is:

Cost of equity = risk free return + market risk premium * Beta
where
Risk free rate = 6%
Market risk premium = Expected Return of the Market – Risk-Free Rate = 14% – 6% = 8%
And since Beta will differentiate based on the debt to equity ratios, and the formula to calculate the Levered Beta would be:
Unlevered Beta = Levered Beta * (1 / (1 + (1 – Tax Rate) * Debt to Equity Ratio))
Levered Beta = Unlevered Beta * (1 + (1 – Tax Rate) * Debt to Equity Ratio)
For example, when the debt is accounting for 10 percent of the total capital, Unlevered Beta is 0.85, tax rate is 0.3 as given, then
Levered Beta = Unlevered Beta * (1 + (1 – Tax Rate) * Debt to Equity Ratio) = 0.85 *  (1 + (1 – 0.3) * (0.1/ 0.9)) = 0.9161

Below are all the results of the levered beta:

Debt / Capital Credit
rating
Tax rate Levered Beta
10% AAA 0.3 0.9161
20% AA 0.3 0.9988
30% A 0.3 1.105
40% BBB 0.3 1.2467
50% BB 0.3 1.445
60% B 0.3 1.7425
70% C 0.3 2.2383

Then since Cost of equity = risk free return + market risk premium * Beta (levered)

Debt / Capital Risk free return Market risk premium Levered Beta Cost of equity
10% 6% 8% 0.9161 13.33 %
20% 6% 8% 0.9988 13.99 %
30% 6% 8% 1.105 14.84 %
40% 6% 8% 1.2467 15.97 %
50% 6% 8% 1.445 17.56 %
60% 6% 8% 1.7425 19.94 %
70% 6% 8% 2.2383 23.91 %

For example, when the debt to capital is 10%, as the risk free ratio is 6% as given, and the market premium is 8% which has been computed above, Beta based on the 11.11% debt to equity ratio is 0.9161, then the correspondent Cost of equity would be:

Cost of equity = risk free return + market risk premium * Beta (levered) = 6% + 8% * 0.9161 = 13.33%

 

4.1.3            Computing the weighted average cost of capital (WACC)

WACC = (Debt / (Debt + Equity)) * Cost of Debt + (Equity / (Debt + Equity)) * Cost of Equity

Because the percentage of debt has been given, therefore,

(Equity / (Debt + Equity) = 1 – (Debt / (Debt + Equity))
For example, when debt ratio is 10%, the equity ratio = 1 – 10% = 90%, with the already calculated above, the WACC calculation would be:

Debt / (Debt + Equity) Cost of Debt Equity / (Debt + Equity) Cost of Equity Weighted average cost of capital (WACC)
0.1 4.55% 0.7 13.33 % 12.45%
0.2 4.97% 0.6 13.99 % 12.19%
0.3 5.46% 0.5 14.84 % 12.03%
0.4 5.95% 0.4 15.97 % 11.96%
0.5 7% 0.3 17.56 % 12.28%
0.6 8.4% 0.2 19.94 % 13.02%
0.7 10.5% 0.1 23.91 % 14.52%

 

Based on the calculation as illustrated in the table, when the debt to capital ratio is 0.4, and weighted cost of debt and equity would reach 11.96 per cent which is the lowest among the seven debt ratios, because of the cost of the capital will be minimized provided to the assumptions made above have all been met, then the value of the firm would be maximized.

4.2    The optimal capital structure identified and other factors

 

With the lowest WACC, it is recommended that the company adopts the optimal capital structure identified according to the computing results because under such debt ratio, 40%, the capital structure is optimal which means that the mix of debt and equity are constructed with balance and the overall cost is controlled under a lowest degree which maximize the income and the stock price (if the company has stocks). Though it is an optimal capital structure according to the relative theories and frameworks, there are additional factors that should be concerned.

 

4.2.1            Industrial average debt to equity ratio

 

As analyzed above, business risk is an important factor deciding the optimal capital structure, and also firms in different industries will be exposed to different level business risks. Therefore, we could expect that capital structure to vary considerably across industries. But for sure, in a given industry, capital structure also varies among firms in different market segments (Brigham & Houston 2009, p. 459), because of the industrial differences the company in this case should not consider only the weighted average cost of the capital, but also should refer to the industrial average debt to equity ratio since it would probably influence how the capital structure would be perceived and analyzed by the investors and the financial rating agencies which in return would attract some unexpected market responses.

 

4.3    Refine the managerial decisions

 

Since in any methods of identifying the optimum capital structure, there are a lot of management decisions to be made in term of estimation of the potential capital structure options, predicting the interest rate that the firm will play and the estimation of the cost of the equity as well as the possibility of the raising of the debt and equity under the certain economic and social environments. Here the management decision and their capabilities based on their actual working experience need to be strengthened in any time which is good for the company. In addition, the direction of the investment should be made by the management rather than the data calculation, and even the company does not own the seemingly best capital mix, it can still generate the above average profit because the management makes an excellent decision regarding how the money should be spent and which project should be focused.

 

4.4    Global and national capital market segmentation

 

4.4.1            Capital market imperfection

 

According to Alan M. Rugman (1996, p. 162), many studies have been done about the imperfections in the international financial markets (that is the degree of segmentation or integration of the national capital markets,) and based on the surveys of Robert Z. Aliber’s and Donald R. Lesards, which found out that international capital market is not perfectly integrated in contrast to the national market integration. Some have believed that because the later emerged markets are not as perfectly developed as what has been done to the US capital market and the UK capital market. As a result, we can see some markets are still quite separated from the international financial market in term of the existence of some restrictions.

 

4.4.2            Government restriction

 

The Chinese market is a classical example where the capital market is restricted by the government regulations to a large extent. Under the Chinese planned system before 1978, funds had been allocated to enterprises by the central and local governments; there had been no need for capital markets for enterprises to raise money. And after 1978, relaxation policies over the business conduct generated capital demand from economic entities. In this context, bonds, stocks and the future contracts came into being in China. With the two stock exchanges established in Shanghai and Shenzhen, respectively, the Chinese capital markets where established. Since then, the reform and development of the stock market and capital market has been mainly driven by the central government (Brink 2011, p. 115). Still right now, Shanghai might be the world’s fifth-largest stock exchange but foreigners are denied open access to it and its sister exchange in Shenzhen. China equity funds run by the major European and foreign investment houses typically can only get a piece of the China success story by investing in Chinese companies like China Mobile and PetroChina that also have a listing on the Hong Kong stock exchange (chinadaily.com.cn 2011). The government restrictions are common in the world, not only in China and other similar developing countries, even in the developed economies, these are common and they are not at all times bad.

 

4.4.3            Love for own country

 

One reason the home market could be more special than the foreign capital markets is that any individual could have special feeling for their own country or local market which makes them prefer such market that they know well since they are children. For example, according to Janet Wasko, Graham Murdock andHelena Sousa (2011), in early modern Europe, capital markets were supported and funded by local citizens. Such market preference behaviors still exist today though they might be less obvious than what happen in the Europe at that time. For example, in China when there are government bonds issued for some special reasons such as for rebuilding after the natural disaster, people would be more than anytime want to buy the bonds no matter how low the interests have been granted because they would like to help those in need after they see what happen through the TV and new reports.

 

4.4.4            Access to the necessary information and channels

 

Before an individual or institutional investor could make any decision to enter into a foreign capital market, they need to collect and evaluate the information necessary to make prudent and productive investment decisions, since they could not attend the corporate governance meeting held in the local market and easily take a visit to the factor to see the production, what they can have all are from the website and the evaluating ranting agencies and market reports, but obviously, these are not enough for the investors to make a final decision to decide whether or not the investments are necessary and sound. What make the situation even worse is that there are language differences and cultural differences that create substantial difficulties and invisible challenges such as the way the information are given (direct or indirect expression due to cultural differences), therefore, the access to the necessary information and investment channels is critical. According to one of my friends’ personal experience who tried to open an account in the US market, there are a lot of procedures to be done in order to open an account, irrespective of the complex document filling and the bank transfer, there are English difficulties that he had to deal with and finally he gave up the attempt simply because of these difficulties. As said by him, if complex as this, he would prefer to invest in the Chinese home market where at least he can read the financial reports very well.

 

4.5     

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