Debt to equity ratios adopted by firms

By | June 15, 2013

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1.        Debt to equity ratios adopted by firms

While there are advantages and disadvantages of the debt finance and also some of the equity finance feature discussed above, one problem appears: how to determine a most appropriate debt to equity ratios that will benefit the company most? Here we will analyze four major debt to equity approaches that have a wide usage in the business practices.

1.1    Net operating income approach

One theory of capital structure is the net operating income approach that argues that the overall cost of capital will remain unchanged no matter what the degree of leverage will be, and so as we increase the proportion of debt in the capital structure the financial risk of the equity shareholder increases, and so investors expect a higher compensation for higher risk (Singhvi & Bodhanwala 2006, p.402). Because the total income and risk which influence the market value of the company would not change, thus under this approach any capital structure will be optimum and theoretically there will be optimum capital structure when there is 100 per cent debt content, this is because with every increase in debt, content K decreases and the value of the firm increases according to Chandra,D and Chandra Bose (2006, p.69). But there are also some limitations of the operating income approach: firstly, estimating a distribution of the operating income is not easy in particular when the company is operating in a unstable business environment which could result in uneven and volatile income; secondly, even when a distribution is estimated, the annual changes in the operating income could be unable to shown the risk of some continual bad years; this operating income approach is also rather conservative as it proposes that the debt payment should not be made out of a company’s operating income and the company has no ways to get access to the financial market; lastly, because the decision is made by the management, there could be conflicts of interest between the management and the owner of the company (Damodaran 2011, p.394).

1.2    Cost of capital approach

The second way of forming the capital structure of a company is the approach of cost of capital calculation. The cost of capital is the expected rate of return that the market participants require in order to attract funds to a particular investment. In the economic terms, the cost of capital for a particular investment is an opportunity cost which is the cost of forgoing the next best alternative investment; it means that an investor will not invest in a particular asset if there is a more attractive substitute (Pratt & Grabowski 2010, p.3). In a Standard Cost of Capital Approach, there factors need to be identified and computed: cost of equity, after tax cost of debts and the overall weighted cost of capital. Investors may notice that in term of the cost of debt computing, since the interest paid on debt instrument is tax deductible, the cost to the enterprise is derived by multiplying the interest rate of the subject debt times 1 minus the entity’s tax rate. The after cost to the enterprise represents its effective rate, possibly subject to adjustment for other cost (Hitchner 2011, p.229).

1.3    Adjusted present value approach

The basic assumption of the adjusted present value approach is that the value of a levered firm is equal to the value of an unlevered firm plus an adjustment for tax saving. The adjusted present value approach express the value of the operations as the sum two components: the unlevered value of the firm’s operations and the present value of the interest tax saving or the interest tax shield (Brigham & Daves 2010, p.905). The main reason for using adjusted present value approach over WACC is that it allows for a varying capital structure during the period under analysis. Analysts can not calculate an appropriate WACC with a capital structure that changes overtime but the adjusted present value approach allows one to reflect the impact of changing debt levels over time. It also accommodates a varying tax rate (Weil,rank,Hughes & Wagner 2007, p.35).

1.4    Comparative analysis approach

When the above three approaches all try to provide a model of deciding the best capital structure, they neglect the behaviors and decision making in the capital structure by the competitors and common decision made in the industry in term of the industry average. For example, if a company calculate a capital structure that minimize the cost of capital using a WACC approach, but it turns out to a much higher rate than the industry level and this could be a warning signal because it could means that investors would not risk their money if it makes the investors feel that the company is too risky in expanding the debt financing. But still because the players in the same industry could have different product mixes, different amount of operating risk, different tax rates and different project returns, hence, the capital structure could have some differences which need to be considered while making such comparisons. Also the industry players could make comparisons between the company and the industry leaders to find out the differences if the company wants to follow the leaders.

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